Transcript LRAS

Chapter 24
The Challenges of Monetary Policy
Copyright ©2006 by South-Western, a division of Thomson Learning. All rights reserved.
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
2
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
3
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
4
The Goals of Monetary Policy
Long Run
Sustainable Economic Growth
determined by the growth and
productivity of labor and capital
Short Run
Full
Employment
Stable Prices
Satisfactory External
Balance compatible
with full employment
and stable prices
Achieving these goals in
the short run helps to
achieve maximum
sustainable economic
growth in the long run
5
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
6
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
7
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
8
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
9
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
10
Steady Noninflationary Growth
Price
Level
1.00
LRAS
LRAS'
B
A
C
AD'
AD
$4,000
LRAS''
$4,120
Real GDP (in Billions)
AD''
$4,244
11
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
12
Unstable Growth
Price
Level
LRAS
LRAS'
LRAS''
I
1.10
D
1.05
1.00
AD''
A
AD'
AD
$4,000
$4,120
Real GDP (in Billions)
$4,244
13
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
14
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
15
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
16
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
17
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
18
Stabilization of Unemployment,
Inflation and the External Balance
• In addition, many firms and households
will pay proportionately more in taxes in an
inflationary environment
19
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%
20
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%
21
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
22
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
23
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
24
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
25
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
26
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
27
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
28
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
29
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
30
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
31
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
32
Steady Noninflationary Growth
Price
Level
1.00
LRAS
LRAS'
B
A
C
AD'
AD
$4,000
LRAS''
$4,120
Real GDP (in Billions)
AD''
$4,244
33
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
34
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)
35
An Unexpected Increase in Aggregate
Demand with No Fed Response
Price
Level
LRAS
SRAS
A
1.00
AD
$1,500
Real GDP (in Billions)
36
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
37
An Unexpected Increase in Aggregate
Demand with No Fed Response
Price
Level
LRAS
SRAS
B
1.05
A
1.00
AD’
AD
$1,500 $1,700
Real GDP (in Billions)
38
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
39
An Unexpected Increase in Aggregate
Demand with No Fed Response
Price
Level
LRAS
SRAS’
SRAS
C
1.10
B
1.05
A
1.00
AD’
AD
$1,500 $1,700
Real GDP (in Billions)
40
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
41
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
42
Possible Policymaker Response to an
Unexpected Rise in Aggregate Demand
Price
Level
LRAS
SRAS
B
1.05
A
1.00
AD’
AD
$1,500 $1,700
Real GDP (in Billions)
43
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
44
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
45
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
46
Demand-Induced Recession
Price
Level
LRAS
SRAS
A
1.00
0.95
B
AD
AD'
Real GDP (in Billions)
47
Demand-Induced Recession
Price
Level
LRAS
SRAS
A
SRAS’
1.00
0.95
B
C
0.90
AD
AD'
Real GDP (in Billions)
48
Demand-Induced Recession
Price
Level
LRAS
SRAS
A
1.00
0.95
B
AD
AD'
Real GDP (in Billions)
49
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
50
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
51
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
52
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
53
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
54
An Adverse Supply Shock as a
Cause of Cost-Push Inflation
LRAS
Price
Level
SRAS'
SRAS
B
A
AD
Real GDP
55
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
56
An Adverse Supply Shock as a
Cause of Cost-Push Inflation
LRAS
Price
Level
SRAS'
SRAS
C
B
A
AD’
AD
Real GDP
57
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
58
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
59
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
60
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
61
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
62
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
63
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
64
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
65
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
66
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
67