C h a p t e r
16
MONETARY
POLICY**
C h a p t e r Key I d e a s
What Can Monetary Policy Do?
A. During 1990s, the U.S. economy performed well, but slowed in 2000. Real GDP shrank
unemployment increased in 2001.
B. Every major country saw its economy slow in 2001; Alan Greenspan and his fellow central
bankers began to cut interest rates to stimulate production and jobs.
C. Can and should monetary policy try to counter recessions? Or should monetary policy focus
more narrowly on price stability?
Outline
I.
*
Instruments, Goals,Targets, and the Fed’s Performance
A. When thinking about monetary policy, it is helpful to distinguish among instruments, goals, and
intermediate targets.
1. The instruments of monetary policy the tools the Fed uses: open market operations, the
discount rate, and the required reserve ratios.
2. The goals of monetary policy are the Fed’s ultimate objectives: to maintain price level
stability and to keep real GDP as close as possible to potential GDP and help maintain
sustainable real GDP growth.
3. The intermediate targets of monetary policy include monetary aggregates such as M1 and
M2, the monetary base, and the federal funds rate.
B. Price Level Stability
1. The economy works best when the price level is stable and predictable.
2. Most economists believe that when the inflation rate is high, the future inflation rate
becomes harder to predict.
3. Price level stability corresponds to an inflation rate that is between 0 and 3 percent a year so
that inflation does not feature in people’s economic calculations.
* This is Chapter 32 in Economics.
357
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CHAPTER 16
C. Sustainable Real GDP Growth
1. The Fed’s actions have indirect effects on real GDP growth.
2. Price level stability contributes to potential GDP growth by creating a climate that favors a
high rate of saving and investment.
3. While it is not known how smooth real GDP growth can be made, smoothing real GDP
fluctuations reduces the effects of swings in aggregate demand and keeps the unemployment
rate close to the natural rate of unemployment, preventing the waste and social problems of
a high unemployment rate.
D. The Fed’s Performance: 1973-2003
1. Shocks to the price level can lessen or intensify inflationary pressures, making the Fed’s job
easier, as in the 1990s, or harder, as in the 1970s and 1980s.
2. Figure 16.1 graphs three measures of monetary policy during the period from 1963–2003.
a)
3.
The thrust of monetary policy can be measured by M2 growth, the federal funds rate,
and/or the real federal funds rate. A rapid growth rate of M2 and/or a low federal funds
rate indicate more expansionary policy.
b) Monetary policy was most expansionary in the 1970s, when inflation was highest.
Monetary policy tends to be expansionary before a presidential election and contractionary
after the election. Exceptions were the terms of Jimmy Carter and George Bush, Sr., both of
whom failed to be reelected.
MONETARY POLICY
359
4.
Figure 16.2 shows how close the
Fed has come to achieving its goals
of price level stability and sustained
real GDP growth over the period of
1973-2003.
a) The Fed did badly in the
1970s, in part because of the
inflationary shocks to the price
level at the time.
b) The Fed did much better in
the 1990s, in part because of
shocks to the price level that
lowered the inflation rate and
kept real GDP close to
potential GDP.
II. Achieving Price Level Stability
A. Monetary policies used to stabilize
aggregate demand fall into three broad
categories:
1. Fixed-rule policies
2. Feedback-rule policies
3. Discretionary policies
B. Fixed-Rule Policies
1.
A fixed-rule policy specifies an action to be pursued independently of the state of the
economy.
2. Milton Friedman proposed a fixed rule that sets the monetary growth rate at a level to
achieve zero average inflation.
C. Feedback-Rule Policies
1.
A feedback-rule policy specifies how policy actions respond to changes in the state of
the economy.
2. The Fed uses a feedback rule when it pushes the interest rate ever higher in response to
rising inflation and strong real GDP growth.
D. Discretionary Policies
1.
2.
A discretionary policy responds to the economy in a possibly unique way that uses all
available information including perceived lessons from past “mistakes.”
Though all policies have some element of discretion, for the most part discretionary policy
is a form of sophisticated feedback rule policy.
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CHAPTER 16
E. A Monetarist Fixed Rule with Aggregate Demand Shocks
1. Figure 16.3 illustrates how
fluctuations in aggregate demand
bring fluctuations in the price level
and real GDP under a monetarist
fixed rule.
a) A decrease in aggregate demand
brings a recession.
b) The quantity of money does
not respond to the state of
aggregate demand. The
economy only adjusts if
aggregate demand or aggregate
supply change.
F. A Keynesian Feedback Rule with Aggregate Demand Shocks
1. Figure 16.4 illustrates how
fluctuations in aggregate demand
are offset by changes in monetary
policy to keep the price level and
real GDP stable.
a) The interest rate and the
quantity of money are
adjusted to offset a change in
aggregate demand.
b) If aggregate demand
fluctuations are perfectly
anticipated, real GDP remains
at potential GDP and the
price level remains unchanged.
G. Policy Lags and the Forecast Horizon
1. Though a feedback rule looks as if
it can stabilize aggregate demand fluctuations, there is a drawback that makes a feedback
rule more problematic:
a) The effects of policy actions operate with lags.
b) These lags might be longer than policymakers can forecast so that actions taken in
response to actual or forecasted events might have their maximum effects only when
the economy faces new problems.
2. Some economists who advocated fixed rules believe that the Fed’s own reactions to the
current state of the economy are a main source of fluctuations in aggregate demand.
H. Stabilizing Aggregate Supply Shocks
1. Real business cycle economists believe that all fluctuations in GDP are caused by
fluctuations in productivity growth, that is, by shifts in the aggregate supply curve. A
slowdown in productivity growth shifts the aggregate supply curve leftward.
MONETARY POLICY
I.
J.
361
2. Cost-push pressure is another reason why aggregate supply can change.
Monetarist Fixed Rule with a Productivity Shock
1. With a fixed rule, a decrease in LAS
has no effect on policy, so AD does
not change, and the result of the
decrease in LAS is a fall in real GDP
and an increase in the price level.
2. Figure 16.5 illustrates a fixed rule in
the face of a productivity shock that
decreases LAS.
Feedback Rules with Productivity Shock
1. With a feedback rule, the impact of a productivity shock on the price level depends on
whether the feedback rule seeks to stabilize real GDP or the price level, but a decrease in
real GDP is an inevitable consequence of a negative productivity shock and no monetary
policy can change the outcome.
a) Under a feedback rule that seeks to stabilize real GDP, the negative productivity shock
will be met with expansionary
monetary policy to boost
aggregate demand and,
ultimately, an increase in the
price level.
b) Under a feedback rule that seeks
to stabilize the price level, the
negative productivity shock will
be met with contractionary
monetary policy to lower
aggregate demand and keep the
price level constant.
2. Figure 16.6 illustrates the two
outcomes that can occur when a
feedback rule is used in the face of a
productivity shock.
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CHAPTER 16
J.
Monetarist Fixed Rule with a Cost-Push Inflation Shock
1. Cost-push inflation originates when cost increases decrease short-run aggregate supply and
shift the SAS curve s leftward. Figure 16.7 illustrates the response of a fixed rule in the face
of cost-push pressures that result from an OPEC price increase.
a)
In the face of a leftward shift in the SAS curve, a fixed rule allows the economy to suffer
stagflation whereby real GDP falls and the price level rises. Figure 16.7(a) shows these
effects.
b) Eventually, the SAS curve returns to its original position, and the level of output
returns to full employment.
K. Feedback Rules with Cost-Push Inflation Shock
1. In the face of a leftward shift in the SAS curve, a feedback rule that seeks to stabilize real
GDP increases the quantity of money and so increases aggregate demand. The economy
moves back to full employment but at a higher price level. Figure 16.7(b) shows these
effects.
2. In the face of a leftward shift in the SAS curve, a feedback rule that seeks to stabilize the
price level decreases the quantity of money and so decreases aggregate demand. The
economy avoids any increase in the price level, but real GDP is destabilized. Figure 16.7(c)
shows these effects.
3. Firms and workers have incentives to increase prices and wages under a feedback rule that
seeks to stabilize real GDP because the Fed will accommodate the price and wage hikes. So
this sort of feedback might easily lead to an on-going cost-push inflationary spiral.
MONETARY POLICY
363
III. Policy Credibility
A. A Surprise Inflation Reduction
1. Figure 16.8 illustrates the effect of a surprise inflation reduction using an AS-AD approach
and Phillips curves.
a) In figure 16.8(a), the AD curve unexpectedly shifts leftward, with the price level and
real GDP falling as a recession hits the economy.
b) Figure 16.8(b) shows that if a reduction in the inflation rate is a surprise, a recession
results as the economy moves along a short-run Phillips curve.
B. A Credible Announced Inflation Reduction
1) If the Fed credibly announces its goal to reduce the inflation rate, inflation slows and real
GDP does not change.
C. Inflation Reduction in Practice
2) In practice, most reductions in inflation result in recessions because people do not believe
Fed announcements; rather they base their expectations on Fed actions and so most
reductions in inflation are partially a surprise.
IV. New Monetarist and New Keynesian Feedback Rules
A. Feedback rules that target both the price level and real GDP can avoid cost-push inflation and
increase the credibility of monetary policy. Two such rules are
1. The McCallum Rule
2. Taylor Rule
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CHAPTER 16
B. The McCallum Rule
1.
2.
The McCallum Rule adjusts the
growth rate of the monetary base to
target the inflation rate but also to
take into account changes in the
trend productivity growth rate and
fluctuations in aggregate demand.
Figure 16.9 shows how the
monetary base has grown and how
it would have grown if the Fed had
followed the McCallum rule for the
period of 1973-2003.
C. The Taylor Rule
1.
The Taylor Rule adjusts the
federal funds rate to target the
inflation rate and to take into
account deviations of the inflation
rate from its target and deviations of
real GDP from potential GDP.
2. Figure 16.10 compares actual federal
funds rate to the Taylor rule for
1973 to 2003, and shows that they
are close but not identical.
D. Differences Between the Rules
1. The McCallum rule pays little
attention to current real GDP, while
the Taylor rule responds powerfully
to the current level of real GDP.
2. The McCallum rule targets the
monetary base, while the Taylor rule
targets the federal funds rate.
E. Choosing Between the Rules
1. Monetarists favor targeting the monetary base because it avoids potential indeterminacy in
the price level.
2. Because the Taylor rule raises the interest rate by more than a rise in the inflation rate, it
avoids any indeterminacy. At the same time, by targeting the interest rate, Keynesians
believe the Taylor prevents excessive swings in aggregate expenditure.
MONETARY POLICY
365
Reading Between the Lines
The article discusses the challenge the Fed faced at the end of 2003 as it contemplated whether to hold
interest rates at their historically low level or begin to move them upward. The analysis compares Fed
policy to that implied by a Taylor rule.
New in the Seventh Edition
This chapter is new to the seventh edition, although it draws on some material from Chapter 31 in the
sixth edition. The chapter emphasizes the distinction between instruments, goals, and intermediate targets
when thinking about monetary policy. There is also a lengthy discussion of the Fed’s varying successes
and failures at achieving its goals.
The chapter considers both a feedback rule that seeks to stabilize real GDP and a rule that seeks to
stabilize the price level. here is a discussion of credible feedback rules that target both real GDP and the
price level. In particular, the McCallum rule and the Taylor rule are considered.
The Reading Between the Lines is new, dealing with the challenges the Fed faced at the end of 2003 and
relating its policy to that implied by a Taylor rule.
Te a c h i n g S u g g e s t i o n s
1.
2.
3.
Instruments, Goals, Targets, and the Fed’s Performance
The distinction between instruments and intermediate targets is useful for explaining to students why
monetary policy discussions are often framed in terms of the interest rate, even though the Fed’s
policy actions are largely in terms of open market operations that change the monetary base. Also, the
idea that a measured inflation rate of between 0 and 3 percent corresponds to price level stability
provides an opportunity to review the biases in the CPI. Finally, it is worth using the tendency for
monetary policy to become expansionary before presidential elections to discuss the independence of
the Fed and other central banks. How independent should central banks be? Who should they be
accountable to? There have been proposals for a more independent fiscal authority than Congress.
Ask the students what they think of such proposals.
Achieving Price Level Stability
This section reinforces the idea that monetary policy affects aggregate demand and the price level, but
not potential GDP. Thus, the question of monetary policy becomes how to best manage aggregate
demand. Students might initially think it obvious that discretionary policy is best. To get students to
think more deeply about the role of rules in policy and about the tradeoffs between fixed- and
feedback-rule policies, it can be useful to have students divide into groups to present arguments in
favor of one of the approaches to monetary policy (discretionary, fixed-rule, feedback-rule that seeks
to stabilize real GDP, and feedback-rule that seeks to stabilize the price level) and against the other
approaches. From this, they will learn the contexts in which their policy approach works best and
what its drawbacks are.
Policy Credibility
This section provides another chance for students to see the Phillips curve and the AS-AD model
side-by-side. When discussing inflation expectations, the Phillips curve can be somewhat more
elegant than the AS-AD model, but emphasize that it is merely another representation of the same
economic ideas. This section may be a good chance to revisit the question of how independent
central banks should be and the impact of independence on credibility.
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CHAPTER 16
4.
New Monetarist and New Keynesian Feedback Rules
This section is great because it deals with concrete and specific policy suggestions by supposed ivorytower academics about what feedback rules should be followed. This is a contemporary and
important policy issue about which there is much debate even within the Federal Reserve system.
While the McCallum rule and the Taylor rule are different, they both involve an explicit inflation
target. A good topic for class discussion is what the inflation target should be; many students will not
immediately realize that there are good arguments for low but positive, rather than zero, inflation as
the target. (The most important being the negative consequences of falling asset prices if there is any
dispersion of individual prices around the mean of zero, which of course there will be; and the
potential for rigidities in the labor market if the mean rate of nominal wage increase is lowered to the
rate of labor productivity increase.) Also, the “credibly announced reduction” idea in the previous
section is one of the most difficult for many students to accept. The addition of the discussion of the
Taylor rule may help with this, because it makes very clear that the basic problem is that privatesector decision makers base their decisions on what the Fed does, not what it says. If the Fed is being
shown to follow a simple, clear, rule, then the inflation target becomes wholly credible if the rule is
credible.
The Big Picture
Where we have been
Chapter 16 makes much use of the aggregate demand and supply model, first developed in Chapter
7, and refined in other chapters. A related, though less important framework, is the concept of the
Phillips curve, which was covered in Chapter 12 on Inflation. Chapters 10 and 11, wherein money
and monetary policy are discussed, as well as Chapter 14, wherein causes of business cycles are
described, provide important, though implicit, background material.
Where we are going
Chapter 16 is the final macroeconomics core chapter so not much of it is used in the following
chapters on the Global Economy.
O v e r h e a d Tr a n s p a r e n c i e s
Transparency
100
Text figure
Figure 16.3
Transparency title
A Fixed Rule with AD Shocks
101
Figure 16.4
A Feedback Rule with AD Shocks
102
Figure 16.5
A Fixed Rule with LAS Shocks
103
Figure 16.6
Feedback Rules with LAS Shocks
104
105
Figure 16.7
Figure 16.8
Three Stabilization Policies: Cost-Push Shock
The Role of Credibility
MONETARY POLICY
367
Electronic Supplements
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in Microsoft Word, and PowerPoint files. All test banks are available in Test Generator Software.
Additional Discussion Questions
11. Two policy goals are discussed in the chapter: achieving price level stability and achieving sustainable
real GDP growth. Which of these goals do you think is more important? Why?
12. How is a discretionary policy related to a feedback-rule policy?
13. What reasons might make activist policy less successful in meeting policy goals?
14. Do you favor fixed rules or feedback rules for stabilization policies? Why?
15. According to many economists, the Federal Reserve can have a significant impact on the U.S.
economy. Should the Federal Reserve be more or less independent of the political process?
16. Describe the McCallum rule, and explain why monetarists would favor the rule to other feedback
rules.
17. Describe the Taylor rule, and explain why Taylor suggests that it would improve the macro
performance of the economy.
18. What should the target rate of inflation be, in your opinion? Why?
19. How would you want the Fed to respond to a cost-push inflation? Why?
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CHAPTER 16
Answers to the Review Quizzes
Page 391
(page 763 in Economics)
1.
2.
3.
Page 398
The instruments of monetary policy are open market operations, the discount rate, and the
required reserve ratio. The goals of monetary policy are price level stability and sustained real GDP
growth. The intermediate targets of monetary policy are monetary aggregates such as M1 and M2,
the monetary base, and the federal funds rate.
Price level stability keeps the inflation rate predictable, which contributes to potential GDP
growth by creating a climate that favors a high rate of saving and investment.
The federal funds rate trended upward from 1973 though 1981, downward through 1993, was
flat through 2001, and then trended downward again in 2002. The real federal funds rate fell
through 1975 and then increased to a peak in 1981. It then followed the trends of the federal
funds rate. During the early 1970s, M2 grew at a rapid rate. It remained high until 1983, fell
steadily through 1994, increased during the late 1990s, and remained high through 2003.
Monetary policy was highly inflationary during the 1970s. Monetary policy was most successful in
achieving its goals in the 1990s.
(page 770 in Economics)
1.
2.
3.
4.
5.
Page 400
Fixed-rule policies keep policy steady and independent of the state of the economy. A fixed-rule
monetary policy is to keep the quantity of money growing at a constant rate. One fixed rule in
everyday life is to brush your teeth every morning. Another fixed rule is to see a movie every Friday
evening.
A feedback monetary policy speeds up money growth when the economy is in a recession and
slows money growth when the economy is in an expansion. One feedback rule in everyday life is
to change the route you drive to work depending on what you hear on the radio about traffic
congestion. Another feedback is to study harder in a class when an exam is approaching.
Feedback rules require knowledge of the source of the economic shock (demand side or supply
side); need the ability to forecast economic conditions as far ahead as the policy actions have
effects; and must have clarity to the public about the feedback rules being used.
A fixed rule of keeping the quantity of money growing at a constant rate or a feedback rule that
adjusts the interest rate and the money growth rate to stabilize the price level prevent inflation in
the face of a productivity growth slowdown.
A fixed rule of keeping the quantity of money growing at a constant rate or a feedback rule that
adjusts the interest rate and the money growth rate to stabilize the price level protect the price level
from cost-push pressures.
(page 772 in Economics)
1.
2.
When inflation is tamed, a recession usually results because people form policy expectations based
on past policy actions. Hence the decrease in the inflation rate is usually unexpected, so the
decrease in inflation results in a decrease in real GDP and increase in unemployment.
By establishing the reputation of being an inflation fighter, the Fed has strengthened the
expectation that it will maintain low inflation. Hence the public’s expected inflation rate remains
low, so that money wages do not increase solely because people expect higher inflation.
(Alternatively, the short-run Phillips curve does not shift upward because people’s expected
inflation rates remain low.)
MONETARY POLICY
Page 403
369
(page 775 in Economics)
1.
2.
The McCallum rule has the monetary base grow at a rate equal to the target inflation rate plus the
10-year moving average growth rate of real GDP minus the 4-year moving average of the growth rate
of the velocity of circulation of the monetary base.
The Taylor rule has the federal funds rate set equal to the target inflation rate plus 2.5 percent plus
one half of the gap between the actual inflation rate and the target inflation rate plus one half of the
percentage deviation of real GDP from potential GDP.
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CHAPTER 16
Answers to the Problems
1.
2.
3.
4.
a. Real GDP is $7 trillion and the price level is 110.
These values are determined at the intersection of AD0 and SAS0.
b. Real GDP falls to $6 trillion and the price level falls to 105. Then, as aggregate demand returns
to AD0 the price level and real GDP return to their initial levels.
c. Real GDP falls to $6 trillion and the price level falls to 105. The Fed increases the quantity of
money to boost aggregate demand to AD0 and the price level and real GDP return to their initial
levels. Aggregate demand then increases (because the decrease is temporary), and real GDP rises
above potential GDP. An inflationary gap arises. The money wage rate rises and so does the
price level. Real GDP moves back toward potential GDP.
d. Real GDP falls to $6 trillion, and the price level falls to 105. The economy is stuck at this point
until the money wage rate falls, short-run aggregate supply increases, and the economy moves
back to potential GDP at an even lower price level. This move will likely take a long time.
e. Real GDP falls to $6 trillion, and the price level falls to 105. The Fed increases the quantity of
money to boost aggregate demand to AD0 and the price level and real GDP return to their initial
levels. Because the decrease in aggregate demand is permanent, this is the end of the action.
a. Real GDP is $7 trillion and the price level is 110.
These values are determined at the intersection of AD0 and SAS0
b. The decrease in aggregate supply could be caused by an increase in money wage rates or by an
increase in the money price of a key raw material.
c. Real GDP falls to $6 trillion and the price level rises to 125. Then, as aggregate supply returns to
SAS0 the price level and real GDP return to their initial levels.
d. Real GDP falls to $6 trillion and the price level rises to 125. The Fed increases the quantity of
money to boost aggregate demand and real GDP returns to its initial level but the price level
rises to 130. If the group that initially decreased aggregate supply repeats its activity (for
instance, raises money wages once again), real GDP decreases and the price level rises still higher.
If the Fed responds according to its feedback rule, a free wheeling cost-push inflation is
underway.
a. The economy might have gotten into its described state because of a combination of rapid
growth of the quantity of money (which brings inflation) and large structural changes (which
bring high unemployment and slow productivity growth).
b. A slowdown in money growth will lower the inflation rate. With a lower inflation rate, inflation
will be more predictable. Price level stability might have an indirect positive impact on potential
GDP growth by creating a climate that favors a high rate of saving and investment. The Fed is
more constrained in its ability to lower unemployment. If the unemployment rate is higher than
the natural rate of unemployment, the Fed will face a tradeoff between lowering inflation or
lowering unemployment. If the unemployment is at its natural rate, the Fed will be unable to
lower unemployment permanently and can only lower it temporarily by pursuing policy that
increases inflation.
c. Lowering the money growth rate lowers the inflation rate by decreasing the speed at which
aggregate demand expands over time. Following the quantity theory of money, the lower growth
rate corresponds to a lower rate of inflation. The short-run tradeoff between inflation and
unemployment is represented by the short-run Phillips curve.
a. The economy might have gotten into its described (happy!) state because of a combination of
slow growth of the quantity of money (which brings low inflation) and rapid technological
change, high national saving, and rapid increase in human capital (which bring low
unemployment and high productivity growth).
MONETARY POLICY
b.
c.
5.
a.
b.
c.
6.
a.
b.
c.
7.
a.
b.
8.
a.
b.
371
Though it is hard to improve upon the state of affairs described in the question, the government
could slow money growth even more to further lower the inflation rate. Alternatively, the Fed
could lower unemployment and speed real GDP growth in the short run by increasing the
money growth rate.
Slowing the money growth rate lowers the inflation rate by decreasing the speed at which
aggregate demand expands over time. If the alternative policy of increasing the money growth
rate is pursued, it will lead to demand-pull inflation that temporarily pulls real GDP above
potential GDP and unemployment below the natural rate of unemployment.
These policy actions were part of a feedback rule. The actions were taken because of the crises.
The required domestic policies all decrease aggregate demand. They lower real GDP and lower
the price level (compared with what would have happened).
A possible criticism, and one that some economists have made, is that the countries should have
adopted policies to expand real GDP even at the risk of a rise in inflation, rather than adopt
policies that decrease aggregate demand.
The policy action was part of a feedback rule. The action was taken because of the Fed’s concern
that slow growth in other world economies would spread to the United States, so the Fed
wanted to speed U.S. economic growth.
The cut in interest rates increased aggregate demand. It raised real GDP and raised the price
level (compared with what would have happened).
A possible criticism, and one that some economists have made, is that to cut interest rates, the
Fed increased the growth rate of the quantity of money. By increasing the growth rate of the
quantity of money, the Fed risked re-igniting inflation. Indeed, in 1999 the Fed became
concerned about the possibility that inflation would recur and increase, so the Fed raised interest
rates in 1999. Then, in 2001, the Fed became worried about recession again and cut interest
rates repeatedly and sharply.
Anything that slows investment in physical or human capital or slows the pace of technological
change will create a productivity growth slowdown. The U.S. productivity growth slowdown of
the 1970s corresponded to a slowdown in the pace of technological change.
Monetary policy does not have a direct effect on the growth of potential GDP. Monetary policy
can only indirectly help economic growth by pursuing price level stability, which creates a
climate that favors a high rate of saving and investment.
A nation’s saving rate is the sum of its government saving rate plus its private saving rate. The
nation’s saving rate might fall because the government saving rate falls and/or the private saving
rate falls. The government saving rate falls when the government budget surplus gets smaller or
the budget deficit gets larger. The private saving rate falls when people decrease their saving and
boost consumption expenditure.
Monetary policy is limited in its ability to affect saving in the long run. The main thing
monetary policy can do is pursue price level stability, which reduces the risks associated with
unanticipated inflation for savers.