prem_ppt_ch17.ppt

Chapter Seventeen
Monetary Policy:
Goals and Tradeoffs

Copyright © Houghton Mifflin Company. All rights reserved. 17 | 2
• The Fed faces a tradeoff between inflation
and unemployment
• Changes in monetary policy often have
opposite effects on each
• The Fed’s goals are assessed in terms of
– Output
– Unemployment rate
– Inflation rate
Monetary Policy:
Goals and Tradeoffs

• Expansionary monetary policy causes the
economy to grow faster in the short run
– Increases in the money supply
– Output is higher, unemployment lower, and inflation
rate is higher over time
• Contractionary monetary policy causes the
economy to grow more slowly in the short run.
– Decreases in the money supply
– Output is lower, unemployment higher, and inflation
rate is lower over time
Stabilization Policy

• Expansionary Monetary Policy
M ↑ ; Y ↑ short run; P ↑ long run
• Contractionary Monetary Policy
M ↓ ; Y ↓ short run; P ↓ long run

If monetary policy is used successfully to temper business cycle
fluctuations, cycles stay closer to the trend line

If monetary policy is not used successfully to temper business
cycle fluctuations, then the fluctuations are more severe

• Stabilization policy may not work if lags are
severe
• Types of lags
– Data Lag
– Recognition Lag
– Decision Lag
– Implementation Lag
– Effectiveness Lag (long and variable lag)
• 6 to 9 months before maximum impact on output
• 12 to 18 months before maximum impact on inflation
Lags in Stabilization Policy

• Goals at founding of Fed (Federal
Reserve Act, 1913)
1. Provide an elastic currency (gold standard
and interest rates)
2. Afford means of rediscounting commercial
paper (discount loans)
3. Establish a more effective supervision of
banking
Goals of Monetary Policy

• Goals from Employment Act of 1946
– Fed should use its tools to increase
employment and production (based on
Keynesian theory)
• Goals from Humphrey-Hawkins Act of
1978
– Promote full employment and production,
increase real income and balanced growth,
and reasonable price stability . . .
Goals of Monetary Policy (cont’d)

• Today
– Short run: maximize output to keep
unemployment low
– Long run: maintain a low rate of inflation
• Focus on three variables
– Output
– Unemployment rate
– Inflation rate
Goals of Monetary Policy (cont’d)

• A major goal of the Fed is to maximize
output
– Output above potential means more work
than people desire in the long run
– Output below potential means unemployed
resources, inefficiency
– The problem: determining level of potential
output in practice is difficult
Output

Gray bars denote recessions, when output growth always falls below zero
Output (cont’d)
Figure 17.4 U.S. Output Growth Since 1960

• Potential output is the amount that would
be produced by the economy if all
resources were being used efficiently
• Monetary policy alone does not determine
output growth; potential output concept
was developed to help account for these
additional factors
• While actual output can exceed potential
in the short run, it is not sustainable
Potential Output

Actual output sinks below potential the most during recessions
Potential Output (cont’d)
Figure 17.5 Actual and Potential U.S. Output Since 1960

• The actual unemployment rate is ideally
equal to the natural rate of unemployment
• The natural rate of unemployment is
that rate when the economy is producing
output equal to its potential
• Natural rate of unemployment reflects
structural unemployment and frictional
unemployment, so it is never zero
Unemployment

• Costs of high unemployment (above the
natural rate)
– Loss of output
– Societal costs, including crime
• Costs of low unemployment (below the
natural rate)
– Difficult to match workers and jobs
– Wage inflation
Unemployment (cont’d)

• A key issue in
stabilization policy is
determining the natural
rate of unemployment
in real time.
– Not directly observable
– Estimates created long
after the fact

Unemployment has only fallen below 4% in the expansion of the 1960s
and again in 2000
Figure 17.6 U.S. Unemployment Rate Since 1960

Unemployment may rise high above the natural rate during recession
Figure 17.7 Actual and Natural Rate of U.S. Unemployment Since 1960

• Again not determined exclusively by
monetary policy
• The consumer price index (CPI) is most
widely used to measure inflation
• Exclude food and energy prices, to get
handle on long-term trend in short run
Inflation

During the last 20 years, inflation has declined
Inflation (cont’d)
Figure 17.8 U.S. CPI Inflation Rate Since 1960

• Costs of Unanticipated Inflation
– Prices are set wrong
– Wealth redistribution between borrowers and lenders
– Leads to greater uncertainty about the future inflation
rate
• Unanticipated inflation problems are worse the
higher the inflation rate, because people are less
able to tell the direction the rate will go
Costs of Inflation

• Costs of Anticipated Inflation
– Inflation is an implicit tax on holding money
– Firms face menu costs of changing prices
– Hurts people on fixed nominal incomes
– Interacts with tax system to hurt saving and
investment
– Housing market distorted by mortgage tilt
problem
• The real value of nominal mortgage payments
declines over time
Costs of Inflation (cont’d)

Inflation erodes the real value of a constant-dollar mortgage payment
Figure 17.9 The Mortgage-Tilt Problem

• The ideal inflation rate is the rate that
policymakers would like to achieve
because it minimizes the costs to society
of changing prices
• Also referred to as inflation targeting
because it represents the Fed’s long-term
goal for the inflation rate
The Ideal Inflation Rate

• Assigns numbers to enable policymakers
to assess alternative policies
1. Output Gap: measures what output level
would be necessary if there were no
recessions
2. Unemployment Gap: measures how close
the unemployment rate is to the natural rate
3. Inflation Gap: measures how close the
inflation rate is to the ideal rate
The Fed’s Objective Function

• Output gap = percentage deviation of
output from potential output
• Positive output gap means output above
potential output; negative means output is
below potential
Output Gap
100
~
*
*



t
t
t
t
y
y
y
y

Output gaps decline and become negative in recession
Figure 17.10 U.S. Output Gap Since 1960

• Unemployment gap = difference between
unemployment and natural rate of
unemployment
• Okun’s law demonstrates negative relationship
between the output gap and the unemployment
gap
• Since the relationship is tight, we usually use
just one or the other; we use the output gap in
determining the Fed’s objective function
Unemployment Gap

Okun’s Law & the Unemployment Gap
Figure 17.11 Okun’s Law in U.S. Data Since 1960

• Inflation gap = actual inflation rate minus
ideal inflation rate
• Ideal inflation rate is not widely agreed
upon, but probably about 0 to 2 percent
• The U.S. has more often struggled with an
inflation rate that is too high rather than
too low
Inflation Gap

U.S. Inflation Gap
Figure 17.12 U.S. Inflation Gap Since 1960

• Combines measure of output and inflation
gaps in an equation
– Summarizes the total cost to the economy of
both gaps.
• Also called the Fed’s loss function
Total loss = Sum over time of [output
loss + (w x inflation loss)]
output loss = output gap squared
inflation loss = inflation gap squared
Equation for Fed’s Objective Function

Equation for Fed’s Objective
Function (cont’d)
• Weight on inflation terms (w) determines
aggressiveness of response to inflation
or the output gap
• The Fed places more weight to the
inflation loss and less to output loss
• The weight on inflation determines how
inflation and output change over time
after a shock hits the economy
 
2
2 ~
(
~
t
t
time
w
y 


 

• The Phillips Curve illustrates the trade-off
between inflation and unemployment
π = α – βU
• This relationship suggests that
policymakers may choose between
inflation and unemployment
The Phillips Curve

The solid trend line illustrates Phillips’ tradeoff
The Phillips Curve (cont’d)
Figure 17.13 Phillips Curve from 1948 to 1965

The tradeoff seems to disappear after the 1960s
Figure 17.14 Phillips Curve Since 1948

• Since the 1960, economists have modified
the theory to account for expected
inflation
π = πe – β(U – UN)
• There is a tradeoff in the short run, but not
in the long run

The long run Phillips curve is vertical at the natural rate of
unemployment, while the short run curve is associated with a particular
expected inflation rate

With a sudden, unexpected increase in the money supply, short run
inflation rises, but declines as the economy readjusts

A permanent increase in the money supply changes the inflation
rate in the long run

Figure 17.18 The Shifting Short-Run U.S. Phillips Curve Since 1948

• Rewrite equation in terms of gaps
π – πe = – β(U – UN)
• Inflation surprise = – β x unemployment
gap
• This better reflects the short vs. long run
Phillips curve tradeoffs

Figure 17.19 Expectations-Augmented Phillips Curve Since 1960

prem_ppt_ch17.ppt

Recommended

Recommended

More Related Content

Similar to prem_ppt_ch17.ppt

Similar to prem_ppt_ch17.ppt (20)

More from ShahidRandhwa

More from ShahidRandhwa (20)

Recently uploaded

Recently uploaded (20)

prem_ppt_ch17.ppt