Chapter 13
Macroeconomic
Policy and
Aggregate Demand
and Supply Analysis
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Preview
• To understand the objectives of
macroeconomic policy
• To understand the relationship between
stabilizing inflation and stabilizing economic
activity
• To understand the Taylor rule of monetary
policy
• To examine how policymakers use
macroeconomic policy to stabilize inflation
and output fluctuations
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The Objectives of
Macroeconomic Policy
• Two primary objectives of macroeconomic
policy:
– Stabilizing economic activity
– Stabilizing inflation around a low level
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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
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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-YP) is zero
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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
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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 and stable inflation
• Monetary policy is to maintain inflation, π ,
close to an inflation target, πT—a target
level that is slightly above zero, so that the
inflation gap (π - πT) is minimized
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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”
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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
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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 aggregate output demanded equal to
potential output, or (Y-YP)=0
– The inflation rate is consistent with price stability,
or π = πT
– It is also the long-run real interest rate for the
economy
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FIGURE 13.1 The Monetary Policy Curve
and the Equilibrium Real Interest Rate, r*
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Policy and Practice: The Federal Reserve’s
Use of the Equilibrium Real Interest Rate, r*
• The Federal Reserve Board of Governors and
the Reserve Bank presidents meet in
Washington, D.C. every six weeks to
formulate a target for policy interest rates
• Before each FOMC meeting, the Board staff
distributes projections for the equilibrium
real interest rate, r*, to FOMC members in a
blue-covered document called the Blue Book
• Policymakers actively discuss the r*
projections during FOMC monetary policy
deliberations
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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 YP
– Monetary policy has no 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 of price stability and economic activity
stability
– The divine coincidence occurs as there is no conflict
between the dual objectives of stabilizing inflation and
economic activity
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FIGURE 13.2 Aggregate Demand
Shock: No Policy Response
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FIGURE 13.3 Aggregate Demand Shock:
Policy Stabilizes Output in the Short Run
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Response to a Permanent Supply
Shock
• Policy responses to a negative permanent supply
shock (reducing YP):
1. No policy response
– Results: The short-run AS curve keeps shifting up, so that
both inflation and the real interest rate are higher
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 πT, and the real interest rate finally falls
– 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
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FIGURE 13.4 Permanent Supply
Shock: No Policy Response
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FIGURE 13.5 Permanent Supply
Shock: Policy Stabilizes Inflation
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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 returns to their initial levels.
– In the long run, there is no tradeoff between the two
objectives, and the divine coincidence holds
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FIGURE 13.6 Response to a Temporary
Aggregate Supply Shock: No Policy
Response
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Response to a Temporary Supply
Shock (cont’d)
2. Policy stabilizes 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 πT,
policymakers need to subsequently reverse the autonomous
tightening 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 economic activity
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Response to a Temporary Supply
Shock (cont’d)
3. Policy stabilizes output 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 has not been
stabilized
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FIGURE 13.7 Response to a Temporary
Aggregate Supply Shock: Short-Run
Inflation Stabilization
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FIGURE 13.8 Response to a Temporary
Aggregate Supply Shock: Short-Run Output
Stabilization
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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, even in the short run.
2. If temporary supply shocks are more common,
then a central bank must choose between the
two stabilization objectives in the short run.
3. In the long run, however, there is no conflict
between stabilizing inflation and economic
activity in response to temporary supply
shocks.
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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 self-correcting 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.
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Lags and Policy Implementation
• Lags occur in activist policies that shift the
AD curve:
1.
2.
3.
4.
5.
Data lag
Recognition lag
Legislative lag
Implementation lag
Effectiveness lag
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Policy and Practice: The Activist/Nonactivist
Debate Over the Obama Fiscal Stimulus
Package
• When President Obama entered office in
January 2009, he faced a very serious
recession with unemployment over 7% and
rising
• Many activists argued that the Fed should
aggressively pursue monetary policy in
addition to a massive fiscal stimulus package
• On the other hand, nonactivists opposed the
fiscal stimulus because of its long
implementation lags, which would lead to
increased volatility in inflation and economic
activity
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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 = 2.0 + 2(π - πT) + 2 (Y - YP)
• In terms of the (nominal) federal funds rate:
Federal funds rate = π + 2.0 + 2 (π - πT) +2 (Y - YP)
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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 Fed should raise the real federal funds rate
with an increase in the inflation gap, and vice
versa
– The Fed should raise the real federal funds rate
with an increase in the output gap, and vice versa
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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
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The Taylor Rule in Practice
• The Taylor rule describes the Fed’s control of
the federal funds rate under its two most
recent chairmen, Alan Greenspan and Ben
Bernanke
• Evidence shows that the Fed does not follow
the Taylor rule exactly as this rule does not
explain all the movements in the federal
funds rate
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FIGURE 13.9 The Taylor Rule and the
Federal Funds Rate, 1960-2010
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Policy and Practice: The Fed’s Use Of
The Taylor Rule
• If the Taylor rule is useful as a policy guide,
then why hasn’t the Fed putting monetary
policy on autopilot with a Taylor rule with
fixed coefficients?
– The economy changes all the time, so the Taylor
rule coefficients are unlikely to stay constant over
time
– Economists do not know the current inflation and
output gap with certainty
– Because of lags, monetary policy conduct is a
forward-looking activity the requires the Fed to
forecast inflation and economic activity in the
future
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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 autonomous monetary policy adjustments
– Although monetary policy controls inflation in the long run,
it does not determine the equilibrium real interest rate
– Potential output—and therefore the quantity of aggregate
output produced in the long run—is independent of
monetary policy
– The classical dichotomy and monetary neutrality (Ch.5) hold
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FIGURE 13.10 A Rise in the Inflation
Target
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Causes of Inflationary Monetary Policy
High Employment Targets and Inflation
• The primary goal of most governments (including that of the
U.S.) is high employment but the pursuit of this goal can bring
high inflation
• Activist stabilization policy to promote high employment can
result in two types of inflation:
– Cost-push inflation—results either from a temporary
negative supply shock or wage hikes beyond what
productivity gains can justify
– Demand-pull inflation—results from policymakers
pursuing policies that increase aggregate demand
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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 to the
right
– However, unemployment will rise again because the shortrun 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
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FIGURE 13.11 Cost-Push Inflation
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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 YT
– However, wages would subsequently increase,
shifting the short-run AS curve up and to the left,
resulting in a steadily rising inflation rate
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FIGURE 13.12 Demand-Pull Inflation
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Application: The Great Inflation
• In 1965-1973, the U.S. economy experienced demandpull inflation as a result of autonomous monetary policy
easing that shifted the AD curve to the right as
policymakers tried to achieve a low unemployment target
of 4%
• Most economists today agree that the natural rate of
unemployment was instead 5% or 6%, so that the 5%
unemployment target initiated the inflationary episode
• After 1975, high expected inflation resulted from the
demand-pull inflation shifted the short-run AS curve
upward and to the left, causing rising unemployment that
policymakers tried to reduce by autonomous monetary
policy easing
• The process of shifting both short-run AS and AD curves
resulted in a continuing rise in inflation
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FIGURE 13.13 Inflation and
Unemployment, 1965-1982
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FIGURE 13.13 Inflation and
Unemployment, 1965-1982 (cont’d)
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