Transcript PPT

Chapter 16
Monetary Policy
MODERN PRINCIPLES OF ECONOMICS
Third Edition
Outline
 Monetary Policy: The Best Case
 The Negative Real Shock Dilemma
 When the Fed Does Too Much
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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?
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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
2007.
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Monetary Policy: Best Case
 Suppose that the rate of growth of the money supply
falls.
 This causes a fall in aggregate demand and a decline in
the growth rate of output.
 Eventually the economy will recover from the negative
monetary shock, if reduction in money supply is
permanent.
 Wages are sticky so the adjustment takes time and
considerable unemployment before the economy adjust
to the decline in money supply.
 The Fed can use monetary policy to reduce the length
and severity of a recession.
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Monetary Policy: Best Case
Inflation
Rate (p)
LRAS
Private
decrease
7%
Short-run aggregate supply (SRAS)
(E(p) = 7%)
Negative shock to AD:
↓ M → ↓ AD
↓p, ↓ growth
6%
AD (M  v)  10%
AD (M  v)  5%
-1%
3%
Real GDP growth rate
Monetary Policy: Best Case
Inflation
Rate (p)
LRAS
Short-run aggregate supply (SRAS)
(E(p) = 7%)
7%
Fed Response:
↑ M → ↑ AD
↑p, ↑ growth
6%
Fed
increase
AD (M  v)  10%
AD (M  v)  5%
-1%
3%
Real GDP growth rate
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
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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.
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Decreasing AD
 Some feel the Federal Reserve overstimulated
the economy in the 1970s, resulting in an
inflation rate of 13.5% by 1980.
 By 1983, tough monetary policy had reduced
the inflation rate to 3%.
 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 many years of
economic growth.
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Definition
Disinflation:
a significant reduction in the rate of
inflation.
Deflation:
a decrease in prices, that is, a negative
inflation rate.
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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.
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Definition
Credible monetary policy:
a monetary policy is credible when it is
expected that a central bank will stick
with its policy.
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Self-Check
A decrease in the rate of inflation is called:
a. Deflation.
b. Disinflation.
c. Recession.
Answer: b – disinflation.
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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.
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Market Confidence
• Uncertainty—the opposite of confidence…
 Drives people to hold more cash:
 Velocity falls: ↓
 Lending falls: ↓ M falls, AD falls
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Definition
Market confidence:
One of the Federal Reserve’s most
powerful tools is its influence over
expectations, not its influence over the
money supply.
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Market Confidence
 For example, uncertainty increased after the
terrorist attacks of September 11, 2001.
 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.
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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?
 https://www.youtube.com/watch?v=INmqvibv4UU
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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.
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Monetary Policy Dilemma
Inflation
rate (p)
New
LRAS
Old
LRAS
Real shock: LRAS curve
shifts left.
The economy moves from
a → recession at b.
New
SRAS
8%
b
a
AD (M  v)  5%
-3%
3%
Real GDP growth rate
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Monetary Policy Dilemma
New
LRAS
Inflation
rate (p)
Old
LRAS
If the Fed  M, this moves
the economy to lower
inflation but even lower
growth at c.
8%
b
c
a
AD (M  v)  5%
-3%
3%
Real GDP growth rate
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Monetary Policy Dilemma
Inflation
rate (p)
New
LRAS
13%
Old
LRAS
If the Fed increases AD,
The  M → some growth,
but much higher inflation.
c
8%
b
a
AD ( M  v)  12%
AD (M  v)  5%
-3%
3%
Real GDP growth rate
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Monetary Policy Dilemma
Conclusion:
Monetary policy is less effective at dealing
with a real shock than an AD shock.
i.e. Monetary policy is difficult
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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.
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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?”
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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 2000.
 The Fed kept pushing down the Federal Funds rate
from about 6.5% at the end of 2001 and held it at 1%
until 2004.
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When the Fed Does Too Much
Unemployment and the Federal Funds Rate 1998 – 2005
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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-2005.
 In 2006 housing prices peaked, and by 2007
were in free fall.
 The real estate crash contributed to a freezing
up of financial intermediation.
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When the Fed Does Too Much
Index of Real House Prices, 1990 – 2010
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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.
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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.
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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?
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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.
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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.
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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.
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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.
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Intertemporal Substitution
Would a Rule Have Been Better? Nominal GDP fell significantly
beginning in the 3rd quarter of 2008.
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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.
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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.
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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.
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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.
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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.
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