Chapter 16. MODERN PRINCIPLES OF ECONOMICS Third Edition
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1 Chapter 16 MODERN PRINCIPLES OF ECONOMICS Third Edition Monetary Policy
2 Outline Monetary Policy: The Best Case The Negative Real Shock Dilemma When the Fed Does Too Much 2
3 Introduction In this chapter, we turn to three key practical questions: 1. When should the Fed try to influence AD? 2. When will the Fed be able to influence AD? 3. When will the influence on AD result in higher GDP growth rates? 3
4 Introduction We start with the best case, when it is clear what the Fed should do. We consider some reasons why even in the best case it isn't always clear which course of action is best. We consider why in other cases sometimes it is much harder for the Fed to respond effectively. We learn that there are times when the Fed can contribute to a boom and subsequent bust. We look at the financial crisis that started in
5 Monetary Policy: Best Case Let s start with a negative shock to AD driven by animal spirits emotions such as fear. Suppose the economy has been growing at 3% and the inflation rate is 7%. Consumers become pessimistic, borrowing and spending less. Banks lend less, entrepreneurs cut back on expansions and invest less. The negative shock shifts AD to the left, and the growth rate of output declines. 5
6 Monetary Policy: Best Case Inflation Rate (π) Private decrease LRAS Short-run aggregate supply (SRAS) (E(π) = 7%) 7% 6% Negative shock to AD: M AD π, growth AD (M + v) = 10% -1% 3% AD (M + v) = 5% Real GDP growth rate
7 Monetary Policy: The Best Case Eventually, the economy will recover from the negative AD shock. Fear recedes and the economy returns to its steady state growth level. However, there is slow growth and increased unemployment, or even a recession in the meantime. 7
8 Monetary Policy The Fed can combat this sluggish growth with monetary policy. To shift the AD curve back up and to the right, the Fed can: Increase the rate of growth of the money supply. Reduce interest rates and encourage more borrowing. 8
9 Monetary Policy: Best Case Inflation Rate (π) LRAS Short-run aggregate supply (SRAS) (E(π) = 7%) 7% 6% Fed Response: M AD π, growth -1% 3% Fed increase AD (M + v) = 5% AD (M + v) = 10% Real GDP growth rate
10 Monetary Policy Monetary policy is difficult because: (1)The Federal Reserve must operate in real time when much of the data about the state of the economy is unknown. Data is released with significant lags Data is often amended years later Takes time to analyze 10
11 Monetary Policy (2) The Federal Reserve s control of the money supply is incomplete and subject to uncertain lags. An increase in the money supply typically affects the economy with a lag of 6-18 months If banks aren t willing to lend AD will be affected very little the Fed will undershoot. If the economy recovers before the monetary policy has an effect the Fed can easily produce a higher than desired rate of inflation overshoot. 11
12 Monetary Policy Getting monetary policy just right is not easy. 12
13 Decreasing AD Economies may get stuck between continuing a costly rate of inflation or reducing it at the risk of a recession. Some feel the Federal Reserve overstimulated the economy in the 1970s, resulting in an inflation rate of 13.5% by The consequence was a very severe recession with an unemployment rate of just over 10%. However, the disinflation slowed inflation and provided the foundation for 25 or so years of economic growth. 13
14 Definition Disinflation: a significant reduction in the rate of inflation. Deflation: a decrease in prices, that is, a negative inflation rate. 14
15 Decreasing AD If a central bank wishes to undertake a disinflation, the policy must be credible. If nominal wage growth is too high, some workers will end up being very expensive and employers will choose to lay them off. So, the key to a less painful disinflation is to increase nominal wage flexibility. Workers will be prepared for slower wage growth and will quickly adjust to the inevitable. A credible disinflation therefore reduces the unemployment effects of disinflation. 15
16 Definition Credible monetary policy: a monetary policy is credible when it is expected that a central bank will stick with its policy. 16
17 Self-Check A decrease in the rate of inflation is called: a. Deflation. b. Disinflation. c. Recession. Answer: b disinflation. 17
18 Market Confidence Fear and confidence are some of the most important shifters of aggregate demand. One of the Federal Reserve s most powerful tools is its influence over expectations, namely its ability to boost market confidence. When investors are uncertain, they often prefer to wait. This is compounded by the bandwagon effect as investors coordinate their actions with others. 18
19 Market Confidence Uncertainty the opposite of confidence Drives people to hold more cash: Velocity falls: Lending falls: M falls, AD falls 19
20 Definition Market confidence: One of the Federal Reserve s most powerful tools is its influence over expectations, not its influence over the money supply. 20
21 Market Confidence For example, uncertainty increased after the terrorist attacks of September 11, If enough people had taken the attack as a signal to reduce investment, the bandwagon effect or uncertainty could have created a severe recession. The Fed increased its lending to banks from $34 million the week before, to $45.5 billion on September 12. This helped stabilize expectations, reduce fear, and raise confidence. 21
22 Market Confidence March 2009 the bottom of the recession Fed announced that it would do whatever necessary to keep the economy from collapsing DJ Industrial average rallied from 6000 to over 18,000 in the next five years Market confidence is perhaps the most powerful tool, more important than the money supply and interest rates Does the Fed always know what it s doing? 22
23 Monetary Policy Dilemma A difficult case for monetary policy is when the economy is hit by a negative real shock, such as a rapid oil price increase. This shifts the LRAS curve to the left, increasing inflation and decreasing GDP growth. A reduction in reduces the inflation rate, but also reduces economic growth. The Fed can increase AD by increasing. But the economy is less productive than before, so most of the increase will show up in inflation. 23
24 Monetary Policy Dilemma Inflation rate (π) 8% New LRAS b Old LRAS New SRAS Real shock: LRAS curve shifts left. The economy moves from a recession at b. a AD (M + v) = 5% -3% 3% Real GDP growth rate 24
25 Monetary Policy Dilemma Inflation rate (π) New LRAS Old LRAS 8% b If the Fed M, this moves the economy to lower inflation but even lower growth at c. c a AD (M + v) = 5% -3% 3% Real GDP growth rate 25
26 Monetary Policy Dilemma Inflation rate (π) New LRAS Old LRAS 13% c If the Fed increases AD, The M some growth, but much higher inflation. 8% b a AD (M + v) = 12% AD (M + v) = 5% -3% 3% Real GDP growth rate 26
27 Monetary Policy Dilemma With a real shock, the central bank must choose between: Too low a rate of growth (with a high rate of unemployment) and Too high a rate of inflation. 27
28 Self-Check A negative real shock poses difficulties for monetary policy because: a. Policymakers can reduce inflation or unemployment but not both. b. Increasing the money supply is politically unpopular. c. Increasing the money supply is illegal. Answer: a. 28
29 When the Fed Does Too Much Is it possible that the Fed makes booms and recessions worse? Is the economy too complex and data too uncertain for policymakers to work with? Did super-low interest rates after the 2001 recession contribute to the housing boom (and crash)? Were the low rates distorted price signals? 29
30 When the Fed Does Too Much In the late 1990s, U.S. economic growth was strong and the unemployment rate was low. The recession that started in 2001 didn't last long, but unemployment continued to increase even after recession had officially ended. Three years after the recession ended, the unemployment rate remained near its recession high. Unemployment kept on increasing until it peaked almost a 50% increase in June 2003 than it was 4% in The Fed kept pushing down the Federal Funds rate from about 6.5% at the end of 2001 and held it at 1% until
31 When the Fed Does Too Much Unemployment and the Federal Funds Rate
32 When the Fed Does Too Much The low Federal Funds rate helped to make credit cheap throughout the economy. It encouraged people to take out more mortgages, bidding up the price of homes. This fueled a speculative bubble in housing. Rates remained very low until mid In 2006 housing prices peaked, and by 2007 were in free fall. The real estate crash contributed to a freezing up of financial intermediation. 32
33 When the Fed Does Too Much Index of Real House Prices,
34 Asset Price Bubbles It s easy to say in retrospect that the Fed should have raised rates sooner or more quickly. There are several problems with this: 1. Few people expected that a fall in housing prices would wreak as much havoc as it did. 2. It s not always easy to identify when a bubble is present. 3. Monetary policy is a crude means of popping a bubble, as it affects the whole economy. 34
35 Asset Price Bubbles The Fed does have the power to regulate banks. It probably could have restrained some of the subprime, no-questions-asked mortgages that later went into default. That would have been the best way of limiting the bubble without taking down the broader economy. Economists have not settled on what to do when asset prices boom. 35
36 Asset Price Bubbles Key question: What, if anything, should the Fed have done in advance of the crash? If interest rates had been raised to cool down the economy, would the result have been A more moderate boom? A more moderate downturn? 36
37 Asset Price Bubbles Monetary policy is a crude means of popping a bubble. It can t push the demand for housing down without pushing the demand for everything else down. Fed could have restrained some of the sub-prime mortgages sold during the boom and later went into default. Conclusion: Monetary policy is difficult in the worst of times and not easy in the best of times. 37
38 Self-Check Which of the following should the Fed have used to limit the recent housing bubble? a. Decrease the money supply. b. Lower interest rates. c. Regulate subprime mortgages. Answer: c regulate subprime mortgages. 38
39 Rules vs. Discretion Ideally, monetary policy tries to adjust for shocks to aggregate demand, but it is often debated whether these adjustments are effective in reducing the volatility of output. Some economists believe the Fed should follow a consistent policy and not try to adjust to every aggregate demand shock. A typical monetary rule would set target ranges for the monetary aggregates like M1 or M2, or for the rate of inflation. A monetary rule works best only when v, monetary velocity, doesn t change rapidly. 39
40 Rules vs. Discretion If M is constant and v falls, then either P must fall or Y must fall. Since prices are sticky, the usual outcome is that both P and Y fall, and a fall in Y means a recession. Other economists have suggested a nominal GDP rule: keep Mv constant (or growing at a constant rate). If Mv doesn t change or grows smoothly, then so does PY, and that would be ideal. 40
41 Intertemporal Substitution Would a Rule Have Been Better? Nominal GDP fell significantly beginning in the 3rd quarter of
42 Rules vs. Discretion If the Fed had followed a nominal GDP rule, the recession of 2008 would have been much milder. The Fed did not increase M enough to make up for a fall in v, even though between August and December of 2008, the monetary base doubled. Whether the Fed should have or could have kept nominal GDP on track is debated. 42
43 Rules vs. Discretion Rules approach: Fed should not try to respond to every shock. Some suggestions Set target ranges for M1 and M2. Set target ranges for inflation. Milton Friedman: Strict rule in which money supply would grow by 3% a year. Allow some adjustments, stated in advance. 43
44 Rules vs. Discretion Discretionary Approach: (current approach) Fed should have the discretion (and flexibility) to do what it thinks best. Discretionary policy has resulted in less volatility. 44
45 Takeaway The Fed has some influence over the growth rate of GDP through its influence over the money supply and thus AD. When faced with a negative shock to AD, the central bank can restore aggregate demand through an expansionary monetary policy. Monetary policy, however, is subject to uncertainties in impact and timing. 45
46 Takeaway If the Fed increases M too much, it may find that it later has to contract M when inflation becomes too high. This process called a disinflation is painful and results in a recession. It is not always possible to achieve both low inflation and low unemployment. Central banking is as much art as science. 46
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