chapter 24 the challenges of monetary policy copyright ©2006 by south-western, a division of...
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![Page 1: Chapter 24 The Challenges of Monetary Policy Copyright ©2006 by South-Western, a division of Thomson Learning. All rights reserved](https://reader036.vdocuments.us/reader036/viewer/2022062516/56649d815503460f94a6564f/html5/thumbnails/1.jpg)
Chapter 24
The Challenges of Monetary Policy
Copyright ©2006 by South-Western, a division of Thomson Learning. All rights reserved.
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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
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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
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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
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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
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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
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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
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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
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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
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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
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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
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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
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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
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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
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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
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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
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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
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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
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Stabilization of Unemployment, Inflation and the External Balance
• In addition, many firms and households will pay proportionately more in taxes in an inflationary environment
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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
nominal inflation expected real after-tax interest rate rate taxes return
0.04 0 (0.25 0.04) 0.03 3%
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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
0.06 2 (0.25 0.06) 0.025 2.5%
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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
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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
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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
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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
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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
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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
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28
Numerical Objectives for Unemployment and Inflation
• In the early years of the 21st 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
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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
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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
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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
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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
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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
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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
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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)
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An Unexpected Increase in Aggregate Demand with No Fed Response
Real GDP (in Billions)
1.00
$1,500
A
AD
LRAS
SRAS
Price Level
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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
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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
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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
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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
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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
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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
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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
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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
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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
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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
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47
Demand-Induced Recession
Price Level
LRAS
SRAS
AD
A
AD'
Real GDP (in Billions)
1.00
B0.95
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48
Demand-Induced Recession
Price Level
LRAS
SRAS
AD
A
AD'
Real GDP (in Billions)
1.00
B0.95
SRAS’
C
0.90
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49
Demand-Induced Recession
Price Level
LRAS
SRAS
AD
A
AD'
Real GDP (in Billions)
1.00
B0.95
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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
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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
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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
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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
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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
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55
An Adverse Supply Shock as a Cause of Cost-Push Inflation
Price Level
LRAS
AD
A
Real GDP
SRAS
SRAS'
B
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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
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57
An Adverse Supply Shock as a Cause of Cost-Push Inflation
Price Level
LRAS
AD
A
Real GDP
SRAS
SRAS'
B
AD’
C
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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
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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
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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
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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
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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
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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
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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
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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
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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
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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