Macroeconomic Policy and Aggregate Demand and Supply Analysis. Reference : Mishkin, Macroeconomics: Policy and Practice, Chapter 12-13

Transcription

1 Macroeconomic Policy and Aggregate Demand and Supply Analysis Reference : Mishkin, Macroeconomics: Policy and Practice, Chapter 12-13

2 The Objectives of Macroeconomic Policy Two primary objectives of macroeconomic policy: Stabilizing economic activity Stabilizing inflation around a low level

3 Stabilizing Economic Activity Economic activity is commonly gauged by the unemployment rate because high unemployment: causes human misery leaves workers and other resources idle, reducing output Instead of a zero rate of unemployment, policymakers target the nature rate of unemployment that is consistent with the maximum sustainable level of employment at which there is no tendency for inflation to increase

4 Stabilizing Economic Activity (cont d) The natural rate of unemployment includes: Frictional unemployment exists when workers and firms need time to make suitable matchups Structural unemployment exists as a mismatch between job skill requirements and worker availability At the natural rate of unemployment, output moves towards potential output, so the output gap (Y-Y P ) is zero

5 Stabilizing Economic Activity (cont d) In practice, identifying the natural rate of unemployment is not straightforward Currently, most economists believe the natural rate of unemployment is around 5%, but still it is subject to much uncertainty and disagreement

6 Stabilizing Inflation: Price Stability High inflation is always accompanied by high variability of inflation, so it reduces economic growth So central banks pursue a policy goal of price stability low andstable inflation Monetary policy is to maintain inflation, π, close to an inflation target, π T a target level that is slightly above zero, so that the inflation gap (π - π T ) is minimized

7 Establishing Hierarchical Versus Dual Mandates A hierarchical mandate requires stable prices as a condition of pursuing other goals Adopted by the European Central Bank (through the Masstricht Treaty), the Bank of England, the Bank of Canada, and the Reserve Bank of New Zealand A dual mandate requires co-equal objectives of price stability and other objectives The Federal Reserve the dual mandate of stable prices and maximum sustainable employment

8 The Relationship Between Stabilizing Inflation and Stabilizing Economic Activity What is a central bank s appropriate policy response to an economic shock? In the case of a demand shock or a temporary supply shock, the central bank can simultaneously pursue stability in both the price level and economic output In the case of a permanent supply shock, however, policymakers can achieve either stable prices or stable output, but not both a tradeoff for a central bank with dual mandates

9 Monetary Policy and the Equilibrium Real Interest Rate At long-run equilibrium, the real interest rate is the equilibrium real interest rate, r*: It is the rate of interest that maintains the quantity of aggregateoutput demanded equal to potential output, or (Y-Y P )=0 The inflation rate is consistent with price stability, or π = π T It is also the long-run real interest rate for the economy

10 FIGURE 13.1 The Monetary Policy Curve and the Equilibrium Real Interest Rate, r*

11 Response to an Aggregate Demand Shock Policy responses to a negative demand shock: 1. No policy response Results: Aggregate output will remain below potential for some time and inflation will fall 2. Policy stabilizes output in the short run Policymakers can autonomously ease monetary policy by cutting the real interest rate, so that the AD curve shifts to the right and output quickly returns to Y P Monetary policy hasno effect on the equilibrium real interest rate, which is the long-run level of the real interest rate In the case of aggregate demand shocks, there is no tradeoff between the pursuit ofprice stability andeconomicactivitystability The divine coincidence occurs as there is no conflict between the dual objectives of stabilizing inflation and economic activity

12 FIGURE 13.2 Aggregate Demand Shock: No Policy Response

13 FIGURE 13.3 Aggregate Demand Shock: Policy Stabilizes Output in the Short Run

14 Response to a Permanent Supply Shock Policy responses to a negative permanent supply shock (reducing Y P ): 1. No policy response Results: The short-run AS curve keeps shifting up, so that both inflation and the real interest ratearehigher

15 FIGURE 13.4 Permanent Supply Shock: No Policy Response

16 Response to a Permanent Supply Shock Policy responses to a negative permanent supply shock (reducing Y P ): 2. Policy stabilizes inflation Policymakers can autonomously tighten monetary policy by raising the real interest rate, so that the output gap becomes zero, inflation is at π T, and the real interest ratefinallyfalls The divine coincidence still remains true when there is a permanent supply shock: there is no tradeoff between the dual objectives of stabilizing inflation and economic activity

17 FIGURE 13.5 Permanent Supply Shock: Policy Stabilizes Inflation

18 Response to a Temporary Supply Shock Policy responses to a negative temporary supply shock (e.g., oil price surges) that shifts the short-run AS curve but not the LRAS curve: 1. No policy response Results: The short-run AS curve shifts back to the initial position, so that output returnsto their initial levels. In the long run, there is no tradeoff between the two objectives, and the divine coincidence holds

19 FIGURE 13.6 Response to a Temporary Aggregate Supply Shock: No Policy Response

20 Response to a Temporary Supply Shock (cont d) 2. Policystabilizes inflation in the short run Policymakers can autonomously tighten monetary policy by raising the real interest rate, which lowers output further below its potential level, but in order to keep inflation at π T, policymakers need to subsequently reverse the autonomoustightening monetary policy Stabilizing inflation in response to a temporary supply shock has led to a larger deviation of aggregate output from potential, so this action has not stabilized economicactivity

21 Response to a Temporary Supply Shock (cont d) 3. Policy stabilizes economic activity in the short run Policymakers can stabilize output rather than inflation in the short run by autonomously easing monetary policy, so that the output gap returns to zero while inflation rises Stabilizing output in response to a temporary supply shock has led to a rise in inflation, so inflation hasnot been stabilized

22 FIGURE 13.7 Response to a Temporary Aggregate Supply Shock: Short-Run Inflation Stabilization

23 FIGURE 13.8 Response to a Temporary Aggregate Supply Shock: Short-Run Output Stabilization

24 The Bottom Line: The Relationship Between Stabilizing Inflation and Stabilizing Economic Activity 1. If most shocks to the macro economy are aggregate demand shocks or permanent aggregate supply shocks, then policy that stabilizes inflation will also stabilize economic activity, evenin theshort run. 2. If temporary supply shocks are more common, then a central bankmust choose between the two stabilization objectivesin theshort run. 3. In the long run, however, there is no conflict between stabilizing inflation and economic activity in response to temporary supply shocks.

25 How Actively Should Policy Makers Try to Stabilize Economic Activity? Nonactivists believe that government action is unnecessary to stabilize economic activity because wages and prices are very flexible and so the selfcorrecting mechanism quickly returns the economy to full employment Activists, particularly Keynesians, argue that the government should pursue active policy to eliminate high unemployment because wages and prices are sticky, and so it takes a long time for the self-correcting mechanism to reach the long run

26 Lags and Policy Implementation Lags occur in activist policies that shift the AD curve: 1. Data lag 2. Recognition lag 3. Legislative lag 4. Implementation lag 5. Effectiveness lag

27 The Taylor Rule The Taylor rule guides the Federal Reserve to set the real federal funds rate, r, at its historical average of 2%, plus a weighted average of the inflation gap and the output gap: r = (π - π T ) + 2 (Y - Y P ) In terms of the (nominal) federal funds rate: Federal funds rate = π (π - π T ) +2 (Y - Y P )

28 The Taylor Rule Versus the Monetary Policy Curve As for the monetary policy curve, the Taylor rule incorporates the inflation gap and output gap: The Central Bank should raise the real federal funds rate with an increase in the inflation gap, and vice versa The Central should raise the real federal funds rate with an increase in the output gap, and vice versa

29 Box: The Difference Between the Taylor Rule and the Taylor Principle The Taylor rule describes how the real interest rate is set in response to the output level and to inflation: It gives a complete description of the conduct of monetary policy in any situation The Taylor principle describes only how the real interest rate is set in response to the level of inflation (ignoring the output level): It gives only a partial description of the conduct of monetary policy

30 The Taylor Rule Versus the Monetary Policy Curve (cont d) In the case of aggregate demand shocks, the Taylor rule suggests a positive relationship between the real federal funds rate and the output gap (shifting the MP curve) In the case of a temporary aggregate supply shock, the Taylor rule requires the Fed to focus on economic activity in addition to inflation

31 Inflation: Always and Everywhere a Monetary Phenomenon Our aggregate demand and supply analysis supports Milton Friedman s adage that in the long run, Inflation is always and everywhere a monetary phenomenon Suppose the central bank chooses to raise the its inflation target, the results are: The monetary authorities can target any inflation rate in the long run with autonomousmonetary policyadjustments Although monetary policy controls inflation in the long run, it does not determinetheequilibriumreal interestrate Potential output and therefore the quantity of aggregate output produced in the long run isindependent ofmonetary policy The classical dichotomy and monetary neutrality (Ch.5) hold

32 FIGURE A Rise in the Inflation Target

33 Causes of Inflationary Monetary Policy High Employment Targets and Inflation The primary goal of most governments is high employment but the pursuit of this goal can bring high inflation Activist stabilization policy to promote high employment can result in twotypes of inflation: Cost-push inflation results either from a temporary negative supply shock or wagehikes beyond what productivity gains can justify Demand-pull inflation results from policymakers pursuing policies that increase aggregatedemand

34 Cost-Push Inflation Suppose a temporary negative supply (cost push) shock occurs, so that the short-run AS curve shifts up and the left, then: Initially output will to a level below its potential, inflation will rise and unemployment will rise In response to an increase in the unemployment rate, activist policymakers with a high employment target would implement expansionary policies to shift the AD curve tothe right However, unemployment will rise again because the short-run AS curve will shift up and to the left as workers seek higher wages to keep their real wages from falling (due to higher inflation) This process continues and continuing inflation occurs

35 FIGURE Cost-Push Inflation

36 Demand-Pull Inflation Suppose policymakers set an unemployment target (4%) that is below the natural rate of unemployment (5%), resulting in expansionary fiscal policy or an autonomous easing of monetary policy that shifts the AD curve upward, then: Policymakers would initially achieve the 4% unemployment rate target so that output is at its target Y T However, wages would subsequently increase, shifting the short-run AS curve up and to the left, resulting in a steadily rising inflation rate

37 FIGURE Demand-Pull Inflation