1. Chapter 24 The Challenges of Monetary Policy Copyright ©2006 by South-Western, a division of Thomson Learning. All rights reserved.

2. 2 The Goals of Monetary Policy Macroeconomic policy consists of –monetary policy the Fed’s use of its policy instruments to affect the cost and availability of funds in the economy –fiscal policy alterations in government spending or taxes proposed and enacted by Congress and the President

3. 3 The Goals of Monetary Policy In conducting monetary policy, the Fed works through the financial system –the Fed’s primary tools include control of the monetary base, the required reserve ratio and the discount rate Monetary policy affects the borrowing, lending, spending, and saving decisions of households, business firms, the government, and the rest of the world

4. 4 The Goals of Monetary Policy The specific goals of monetary policy are to design and implement policies that will achieve –sustainable economic growth –full employment –stable prices –a satisfactory external balance

5. 5 The Goals of Monetary Policy Achieving these goals in the short run helps to achieve maximum sustainable economic growth in the long run Sustainable Economic Growth determined by the growth and productivity of labor and capital Long Run Short Run Full Employment Stable Prices Satisfactory External Balance compatible with full employment and stable prices

6. 6 Economic Growth If the nation’s standard of living is to rise over time, the productive capacity of the economy must expand –growth of the capital stock –growth of the labor force –a rise in productivity

7. 7 Economic Growth The growth of the capital depends on the amount of investment spending undertaken by firms –the change in the capital stock = net investment spending The productivity of capital is related to the amount of resources devoted to research and development and on the resulting technological advances

8. 8 Economic Growth The growth of the labor supply flows from the growth of the population and from increases in labor force participation rates The productivity of labor is thought to depend on the educational attainment and health of workers, the quantity and quality of capital available, and the competitive environment faced by firms and workers

9. 9 Economic Growth In general, a thriving nation’s productive capacity grows over time Macroeconomic policy influences the pace in a number of ways –tax policy can affect a firm’s desire to invest or engage in research and development, and can affect a household’s decision to work and save –interest rates also influence spending and saving decisions

10. 10 Economic Growth A stable environment will also be more conducive to farsighted planning and decision making that enhance an economy’s long-run growth potential –high rates of capacity utilization and employment –output growing at a steady, sustainable rate

11. 11 Steady Noninflationary Growth Price Level Real GDP (in Billions) 1.00 $4,000 A AD LRAS AD' B LRAS' $4,120 C AD'' LRAS'' $4,244

12. 12 Economic Growth An unstable environment characterized by a series of inflationary booms and deflationary recessions is likely to inhibit economic growth –aggregate demand grows faster or slower than aggregate supply

13. 13 Unstable Growth Price Level Real GDP (in Billions) 1.00 $4,000 A AD LRAS I 1.05 AD' D LRAS' $4,120 1.10 AD'' LRAS'' $4,244

14. 14 Economic Growth Short-run stabilization objectives are not separate from the long run goal of economic growth –short-run fluctuations around the trend influence the trend itself

15. 15 Stabilization of Unemployment, Inflation and the External Balance In order for our economic to reach its full potential, all individuals must have the opportunity to become productive, employed members of society –output that could have been produced last year by those unemployed is lost forever

16. 16 Stabilization of Unemployment, Inflation and the External Balance To understand why policymakers worry about inflation, it is useful to distinguish between expected inflation and unexpected inflation Suppose that households expect the inflation rate to be 3% next year –workers will try to secure wage increases of at least 3% –net lenders will also take this into account

17. 17 Stabilization of Unemployment, Inflation and the External Balance Suppose that the inflation rate next year turns out to be 5% –the real wage of workers will fall –firms will wish to expand production because their output price is rising relative to input prices –the real return on financial assets will be less than anticipated

18. 18 Stabilization of Unemployment, Inflation and the External Balance Unexpected inflation redistributes income in arbitrary and unpredictable ways –from workers to firms –from lenders to borrowers –from those on fixed incomes to those with variable incomes that rise with inflation

19. 19 Stabilization of Unemployment, Inflation and the External Balance In addition, many firms and households will pay proportionately more in taxes in an inflationary environment

20. 20 Stabilization of Unemployment, Inflation and the External Balance Suppose that a household earns 4% on its surplus funds, the household is in the 25% tax bracket, and expected and unexpected inflation is zero Its real after-tax return is

21. 21 Stabilization of Unemployment, Inflation and the External Balance Suppose that expected and unexpected inflation is 2% so the nominal interest rate rises to 6% The household’s real after-tax return is now

22. 22 Stabilization of Unemployment, Inflation and the External Balance Since nominal returns are taxed (rather than real returns) inflation results in the government taking a larger portion of interest income Inflation also reduces the real value of nominal money balances held –inflation acts as a tax on money holdings

23. 23 Stabilization of Unemployment, Inflation and the External Balance Researchers have also found that as the inflation rate rises, the variability of inflation tends to increase –the relationship among relative prices becomes more volatile and difficult to predict –pricing, production, saving, and investment decisions have to be made in a more uncertain environment –firms and households will be more cautious in making long-term commitments

24. 24 Stabilization of Unemployment, Inflation and the External Balance Inflation can also affect a nation’s international competitiveness –if prices of goods in the U.S. rise relative to the prices of competing goods in the rest of the world, the demand for U.S. products will fall production and employment in the U.S. will decline U.S. firms could lose a portion of their share of world markets

25. 25 Stabilization of Unemployment, Inflation and the External Balance Policymakers should also be on the alert for deflation –a falling overall price level Deflation can be worse than inflation because it can lead to debt deflation, defaults, and bankruptcies

26. 26 Numerical Objectives for Unemployment and Inflation General guidelines for policymakers are contained in two statutes –the Employment Act of 1946 –the Humphrey-Hawkins Full Employment and Balanced Growth Act of 1978

27. 27 Numerical Objectives for Unemployment and Inflation Both statutes direct policymakers to pursue policies that are consistent with achieving full employment and noninflationary growth –leaves it to policymakers to determine the rate of unemployment consistent with full employment and nonaccelerating inflation

28. 28 Numerical Objectives for Unemployment and Inflation In the early years of the 21 st century, most estimates of sustainable employment imply an unemployment rate of about 4.0 to 4.5% –this is often called the natural rate of unemployment –this is believed to be the unemployment rate that is consistent with stable prices –this is the unemployment rate that corresponds to the natural rate of output

29. 29 Numerical Objectives for Unemployment and Inflation Over time, policymakers desire price stability and often stress that this should be the primary objective of monetary policy –price stability means 0% inflation to some analysts and 1 to 2% inflation to others –economists worry that when the inflation rate is 0%, the economy could slip into a deflation

30. 30 Numerical Objectives for Unemployment and Inflation In setting the inflation goal over the short term, policymakers consider recent experience and attempt to balance their desire to reduce inflation with their desire to minimize the accompanying adverse effects on unemployment and economic growth

31. 31 Numerical Objectives for Unemployment and Inflation In the long run, the goals of stable prices and full employment are believed to be perfectly compatible Based on our historical experience, the potential long-run growth rate for real GDP has been estimated to be between 2.5 to 3% per year

32. 32 Changes in Aggregate Demand and Policy The obvious goals of monetary policy are to achieve successive long-run equilibriums with sustainable noninflationary growth –occurs if both aggregate demand and aggregate supply are shifting out at the same rate

33. 33 Steady Noninflationary Growth Price Level Real GDP (in Billions) 1.00 $4,000 A AD LRAS AD' B LRAS' $4,120 C AD'' LRAS'' $4,244

34. 34 Changes in Aggregate Demand and Policy Unfortunately, the economy may often fall short of achieving these goals –policymakers may need to react to changes or to initiate changes that guide the economy in the right direction

35. 35 Changes in Aggregate Demand and Policy Suppose that the economy is currently in long-run equilibrium –the expected price level is equal to the actual price level –the economy is operating at its natural rate of output ($1,500 billion)

36. 36 An Unexpected Increase in Aggregate Demand with No Fed Response Real GDP (in Billions) 1.00 $1,500 A AD LRAS SRAS Price Level

37. 37 Changes in Aggregate Demand and Policy Suppose that aggregate demand increases unexpectedly In the short-run, the economy will move to point B –output rises to $1,700 billion –the price level rises to 1.05

38. 38 An Unexpected Increase in Aggregate Demand with No Fed Response Real GDP (in Billions) 1.00 $1,500 A AD LRAS SRAS Price Level AD’ B $1,700 1.05

39. 39 Changes in Aggregate Demand and Policy As producers attempt to continue to expand output, input prices will rise –short-run aggregate supply will decrease The economy will return to a new long-run equilibrium at point C –a higher price level –no change in output

40. 40 An Unexpected Increase in Aggregate Demand with No Fed Response Real GDP (in Billions) 1.00 $1,500 A AD LRAS SRAS Price Level AD’ B $1,700 1.05 SRAS’ C 1.10

41. 41 Changes in Aggregate Demand and Policy Policymakers could intervene and act to reduce aggregate demand –tighter monetary policy that reduces the growth rate of money and credit and raises interest rates –slower government spending or an increase in taxes

42. 42 Changes in Aggregate Demand and Policy In either case, the level of spending and aggregate demand would be reduced –the economy would then return to long-run equilibrium at a lower price level –the economy moves from point A to point B and then back to point A

43. 43 Possible Policymaker Response to an Unexpected Rise in Aggregate Demand Real GDP (in Billions) 1.00 $1,500 A LRAS SRAS Price Level AD’ B $1,700 1.05 AD

44. 44 Demand-Induced Recession The initial effect of an unexpected decline in aggregate demand is an unanticipated rise in inventories –in response, business firms will cut production, employment, and prices –output prices tend to fall relative to input prices

45. 45 Demand-Induced Recession Once again, suppose the economy is initially in long-run equilibrium –the expected price level is equal to the actual price level –the economy is operating at its natural rate of output Aggregate demand unexpectedly declines –the economy moves from point A to point B –output and the price level both fall

46. 46 Demand-Induced Recession The economy can take two possible paths back to long-run equilibrium –input prices can decline since the actual price level is lower than the expected price level the short-run aggregate supply curve shifts right the economy moves from point A to point B to point C –policymakers can boost aggregate demand the economy moves from point A to point B and back to point A

47. 47 Demand-Induced Recession Price Level LRAS SRAS AD A AD' Real GDP (in Billions) 1.00 B 0.95

48. 48 Demand-Induced Recession Price Level LRAS SRAS AD A AD' Real GDP (in Billions) 1.00 B 0.95 SRAS’ C 0.90

49. 49 Demand-Induced Recession Price Level LRAS SRAS AD A AD' Real GDP (in Billions) 1.00 B 0.95

50. 50 Demand-Induced Recession Which path does the economy usually take? –recessions generate political pressure for policymakers to “do something” –if firms and households expect policymakers to act, a downward adjustment in prices will be slow to develop and the economy may stagnate leading to even more pressure on policymakers to boost aggregate demand

51. 51 Changes in Aggregate Supply and Policy A supply shock is any event that shifts the aggregate supply curve –a significant rise in the price of oil –major crop failures or national disasters –anything that affects the nation’s productive capacity

52. 52 Changes in Aggregate Supply and Policy Assume that the economy is initially in long-run equilibrium –the expected price level is equal to the actual price level –the economy is operating at its natural rate of output Suppose there is an adverse supply shock –for example, assume the price of oil rises substantially

53. 53 Changes in Aggregate Supply and Policy Firms feel the supply shock immediately –the cost of production rises relative to output price –the short-run aggregate supply curve shifts to the left –the price level rises and output falls the economy moves from point A to point B

54. 54 Changes in Aggregate Supply and Policy Policymakers face a dilemma because the economy is experiencing both inflation and a recession –the economy is experiencing cost-push inflation triggered by increases in input prices –real output is below its natural level

55. 55 An Adverse Supply Shock as a Cause of Cost-Push Inflation Price Level LRAS AD A Real GDP SRAS SRAS' B

56. 56 Changes in Aggregate Supply and Policy Policymakers can boost aggregate demand –this is called accommodation –this will move the economy from point B to point C –the recession will be short-lived –the inflation problem will be magnified

57. 57 An Adverse Supply Shock as a Cause of Cost-Push Inflation Price Level LRAS AD A Real GDP SRAS SRAS' B AD’ C

58. 58 Changes in Aggregate Supply and Policy Policymakers can choose to do nothing –idle plants and unemployment in the economy will put downward pressure on input prices –short-run aggregate supply will eventually shift to the right

59. 59 Changes in Aggregate Supply and Policy Supply shocks are not always adverse –there was a substantial drop in the price of oil in late 1985

60. 60 Summary of Major Points The goal of monetary policy is to influence the overall performance of the economy –the size of the economic pie in the long run is influenced by the growth of the labor force and the capital stock and by increases in the productivity of these inputs –government policies affect incentives to work, invest, and save –to the extent that policies encourage a stable environment, growth is also affected

61. 61 Summary of Major Points In addition to economic growth, full employment, price stability, and a satisfactory external balance are also goals of monetary policy –over the short run, economic growth depends on the growth of aggregate demand to aggregate supply –an unstable short-run environment is believed to have an adverse effect on long-run growth

62. 62 Summary of Major Points Full employment is a goal because if a nation is to reach its full potential, individuals must have an opportunity to become productive members of society Price stability is a goal because inflation tends to redistribute income in arbitrary and unpredictable ways –also contributes to uncertainty –can have an adverse effect on international competitiveness

63. 63 Summary of Major Points When inflation rates are low, policymakers need to be on the lookout for deflation Monetary policy can cause major changes in exchange rates and the balances in the capital and current accounts –must seek to achieve an acceptable external balance compatible with the goals of full employment and stable prices

64. 64 Summary of Major Points General guidelines for the macroeconomic goals are contained in the Employment Act of 1946 and the Humphrey-Hawkins Act of 1978 –specific guidelines and the setting of priorities are the result of historical experience, judgments about what is feasible, and the political environment

65. 65 Summary of Major Points In the short run, an unexpected increase in aggregate demand produces demand-pull inflation and unsustainable increases in output –if policymakers do nothing, the economy returns to long-run equilibrium at a higher price level –if policymakers use appropriate policy, the economy returns to long-run equilibrium at a price level lower than it otherwise would have been

66. 66 Summary of Major Points In the short run, an unexpected fall in aggregate demand will produce a recession –if policymakers do nothing, the economy returns to long-run equilibrium eventually –policymakers can also boost aggregate demand to move the economy back to long-run equilibrium –history shows that this second route has predominated

67. 67 Summary of Major Points Supply shocks cause a shift of the short-run aggregate supply curve –adverse supply shocks pose a dilemma for policymakers –real output and employment can fall while prices rise –an accommodating policy will moderate the recession but will aggravate the inflation