Inflation and Monetary
Policy
Slides by: John & Pamela Hall
ECONOMICS: Principles and Applications 3e
HALL & LIEBERMAN
© 2005 Thomson Business and Professional Publishing
The Objectives of Monetary Policy
• Fed was first established in 1913
– Chief responsibility was to ensure stability of
banking system
• Fed’s objective in 1950s and 1960s
changed to keeping interest rate low and
stable
– In 1970s, Fed’s objectives shifted once again
– As stated in Federal Reserve Banking Act of
1978, which is still in force
• Fed is now responsible for achieving a low, stable
rate of inflation, and full employment of labor force
2
Low, Stable Inflation
• When inflation rate is high, society uses up
resources coping with it
– Resources that could have been used to produce
goods and services
• In addition to keeping inflation rate low, Fed tries
to keep it stable from year to year
• Fed, as a public agency, chooses its policies with
costs of inflation in mind
– Fed has another concern
• Inflation is very unpopular with the public
• A Fed chairman who delivers low rates of inflation is seen as
popular and competent
– While one who tolerates high inflation goes down in history as a
failure
3
Full Employment
• “Full employment” means that unemployment is at normal levels
• Different types of unemployment
– Frictional unemployment is part of normal working of labor market
– While structural unemployment is a serious social problem
• Best solved with microeconomic policies
– Such as job-training programs or improved information flows
• Cyclical unemployment, by contrast, is a macroeconomic problem
– Macroeconomists use term “full employment” to mean absence of cyclical
employment
• Fed is concerned about cyclical unemployment for two reasons
– Opportunity cost
• Output that unemployed could have produced if they were working
– Cyclical unemployment represents a social failure
• Why should Fed try to eliminate only cyclical unemployment?
– Why not go further—pushing output above its full-employment level?
– If unemployment is a bad thing, shouldn’t Fed aim for lowest possible
unemployment rate possible?
• No
4
Full Employment
• Natural rate of unemployment—unemployment rate at which GDP is at
its full-employment level
– With no cyclical unemployment
• When unemployment rate is below natural rate, GDP is greater than
potential output
– Economy’s self-correcting mechanism will then create inflation
• When unemployment rate is above natural rate, GDP is below
potential output
– Self-correcting mechanism will then put downward pressure on price level
• Natural unemployment rate is not etched in stone
– Nor is it the outcome of purely natural forces that can’t be influenced by
public policy
• Why use the term natural for such a changeable feature of the
economy?
– Term makes sense only from perspective of macroeconomic policy
– Isn’t much that macroeconomic policy can do about natural rate
5
Figure 1(a): The Fed’s Performance
Since 1950
6
Figure 1(b): The Fed’s Performance
Since 1950
7
The Fed’s Performance
• How well has Fed achieved its goals?
• Fed has mostly had a good—and
improving—record in recent years
– Inflation rate has been kept low and
relatively stable
– Unemployment has been near and even
below most estimates of natural rate
• Except for most recent recession
8
Federal Reserve Policy: Theory and
Practice
• We’ve assumed Fed’s response to spending shocks is a
passive monetary policy
– When Fed keeps money supply constant regardless of shocks to
economy
• In order to keep real GDP as close as possible to its
potential, Fed must pursue an active monetary policy
– Responds to events in economy by changing money supply
• In some cases, proper response is easy to determine
– Because the same action that maintains full employment also
helps maintain low inflation
• But in other cases, Fed must trade off one goal for another
– Responses that maintain full employment will worsen inflation, and
responses that alleviate inflation will create more unemployment
• We’ll make a temporary simplifying assumption in this
section
– Fed’s goal for inflation rate is zero
9
Responding To Changes In Money
Demand
• Potential disturbances to the economy sometimes
arise from a shift in money demand curve
• How should Fed respond to shifts in money
demand curve?
• If Fed wants to maintain full employment with zero
inflation—an unchanged price level
– Passive monetary policy is wrong response
• By increasing money stock—shifting money
supply curve rightward—
– Fed can move money market to a new equilibrium,
preventing any rise in interest rate
10
Responding To Changes In Money
Demand
• Shifts in money demand curve present Fed
with a no-lose situation
– By adjusting money supply to prevent changes
in interest rate
• Fed can achieve both price stability and full
employment
– Fed sets and maintains an interest rate target
and adjusts money supply to achieve that target
• Fed can achieve its goals of price stability and full
employment simultaneously
11
Figure 2: Responding to Shifts in
Money Demand
12
How the Fed Keeps the Interest Rate
on Target
• Fed officials meet each morning to determine that
day’s monetary policy
– Based on information gathered previous afternoon and
earlier that morning
– Key piece of information is what actually happened to
interest rate since previous morning
• Using this and other information about banking
system and economy, Fed decides what to do
– At 11:30 A.M., if interest rate is above target, Fed buys
government bonds
– If interest rate is below target, Fed sells government
bonds
13
Responding to Other Demand
Shocks
• There are other demand shocks as well, originating with a
shift in aggregate expenditure line
– Fed has a more difficult time responding to this kind of demand
shock
• Suppose there is a positive demand shock that originates
with an increase in aggregate expenditure
• Possible responses by Fed
– Fed could follow a passive monetary policy, leaving money supply
unchanged
• Would lead to an increase in both output and price level
– Fed could pursue active policy of maintaining an interest rate target
• Would increase output and price levels even further
– Pursue an active policy that shifts AD curve back to AD
• Fed must change interest rate target
– Positive demand shock requires an increase in target
– Negative demand shock requires a decrease in target
14
Figure 3: Responding to Demand Shocks that
Originate with Aggregate Expenditure
15
Figure 4: The Best Response to a
Spending Shock
(a)
Interest
Rate (%)
M2s
(b)
Price
Level
M1s
AS
r3
r2
r1
H
F
P2
F
E
P1
E
AD2
d
M2
d
AD1
M1
Money
YFE
Y2
Real GDP
16
Responding to Other Demand
Shocks
• In recent years, Fed has changed its interest rate
target as frequently as needed to keep economy
on track
– If Fed observers that economy is overheating—and that
unemployment rate has fallen below its natural rate—it
will raise its target
• When Fed observers that economy is sluggish—
and unemployment rate has risen above its
natural rate—Fed will lower its target
• Demand shocks that originate with a shift of
aggregate expenditure curve present Fed with
another no-lose situation
– Same policy that helps to keep unemployment at its
natural rate also helps to maintain a stable price level
17
The Interest Rate Target and the
Financial Markets
• Members of Open Market Committee think very
hard before they vote to change interest rate
target
• When Fed moves interest rate to a higher target
level, prices of bonds drop
• Stock market is often affected in a similar way
– Lower the price of a stock, the more attractive the stock
is to a potential buyer
• When Fed raises interest rates, rates of return on
bonds increase, so bonds become more attractive
18
The Interest Rate Target and the
Financial Markets
• Destabilizing effect on stock and bond markets is one
reason Fed prefers not to change interest rate target very
often
• Financial markets are also affected by expected changes
in the interest rate target
– Whether or not they occur
• This is why financial press speculates constantly about
likelihood of changes in interest rate target
– Good news about the economy sometimes leads to expectations
that Fed—fearing inflation—will raise its interest rate target
• This is why good economic news sometimes causes stock and bond
prices to fall
• Similarly, bad news about economy sometimes leads to expectations
that Fed—fearing recession—will lower its interest rate target
– This is why bad economic news sometimes causes stock and bond prices
to rise
19
Responding To Supply Shocks
• Demand shocks in general present Fed with easy
policy choices
• But adverse or negative supply shocks present
Fed with a true dilemma
– If Fed tries to preserve price stability, it will worsen
unemployment
– If it tries to maintain high employment, it will worsen
inflation
• Fed can respond with an active monetary policy
– Changing money stock in order to alter short-run
equilibrium
20
Figure 5: Responding to Supply
Shocks
21
Responding To Supply Shocks
• Let’s imagine two extreme positions
– Fed could prevent inflation entirely by decreasing money stock
• Shifting AD curve leftward to curve labeled ADno inflation
– At the other extreme, Fed could prevent any fall in output
• In practice, Fed is unlikely to choose either of these two
extremes, preferring instead some intermediate policy
• Adverse supply shock presents Fed with a short-run tradeoff
– It can limit the recession, but only at the cost of more inflation
– It can limit inflation, but only at the cost of a deeper recession
• After supply shocks, there are often debates within Fed—
and in the public arena—about how best to respond
– Hawks lean in direction of price stability
– Inflation Doves lean in direction of a milder recession
• More willing to tolerate cost of higher inflation
22
Choosing Between Hawk and Dove
Policies
• When a supply shock hits, should Fed use a hawk
policy, a dove policy, or should it keep the AD
curve unchanged?
• Proper choice depends on how Fed weights harm
caused by unemployment against harm caused by
inflation
• In recent years, some officials at Fed have argued
that having two objectives—stable prices and full
employment—is unrealistic when there are supply
shocks
– Regardless of any future change in Fed’s mandate,
debate between hawks and doves is destined to
continue
23
How Ongoing Inflation Arises
• Best way to begin analysis of ongoing inflation is to explore how it
arises in an economy
• What was special about economy in 1960s?
– Period of exuberance and optimism, for both businesses and households
• Fed could have neutralized positive demand shocks by raising interest
rate target
– Shifting AD curve back to its original position
• Alternatively, Fed could have done nothing
– Allowing self-correcting mechanism to bring economy back to full
employment with a higher—but stable—price level
• Fed made a different choice
– Maintained low interest rate target
• Why did Fed act in this way?
– No one knows for sure, but one likely reason is that, in 1960s, Fed saw its
job differently than it does today
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How Ongoing Inflation Arises
• As price level continued to rise in 1960s, public began to
expect it to rise at a similar rate in the future
• When inflation continues for some time, public develops
expectations that inflation rate in the future will be similar
to inflation rates of recent past
• Why are expectations of inflation so important?
– Because when managers and workers expect inflation, it gets built
into their decision-making process
• A continuing, stable rate of inflation gets built into economy
– Built-in rate is usually the rate that has existed for the past few
years
• Once there is built-in inflation, economy continues to
generate continual inflation
– Even after self-correcting mechanism has finally been allowed to
do its job and bring us back to potential output
25
Figure 6: Long-Run Equilibrium With
Built-in Inflation
26
How Ongoing Inflation Arises
• In an economy with built-in inflation, AS curve will shift
upward each year
– Even when output is at full employment and unemployment is at its
natural rate
• Upward shift of AS curve will equal built-in rate of inflation
• In short-run, Fed can bring down rate of inflation by
reducing rightward shift of AD curve
– But only at the cost of creating a recession
• Would Fed ever purposely create a recession to reduce
inflation?
– Indeed it would, and it has—more than once
• Creating a recession is not a decision that Fed takes
lightly
– Recessions are costly to economy and painful to those who lose
their jobs
27
Ongoing Inflation and the Phillips
Curve
• Ongoing inflation changes our analysis of monetary policy
– Forces us to recognize a subtle, but important, change in Fed’s objectives
• While Fed still desires full employment, its other goal—price stability—is not
zero inflation
– But low and stable inflation rate
• Phillips curve—named after economist A. W. Phillips, who did early
research on the relationship between inflation and unemployment
– Used to illustrate Fed’s policy choices
• Phillips curve is downward sloping
– Because it tells the same story we told earlier—with AD and AS curves—
about Fed’s options in short-run
• In short-run, Fed can move along Phillips curve by adjusting rate at
which AD curve shifts rightward
– When Fed moves economy downward and rightward along Phillips curve
• Unemployment rate increases, and inflation rate decreases
– In long-run a decrease in actual inflation rate leads to a lower built-in
inflation rate and Phillips curve shifts downward
28
Figure 7: The Phillips Curve
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Figure 8: The Shifting Phillips Curve
30
Riding Up the Phillips Curve
• Process of moving down Phillips curve and
thereby causing it to shift downward also works in
reverse
– Moving up Phillips curve will cause it to shift upward
• At this point, if Fed returns economy to full
employment, we end up at point J
– Economy will be back in long-run equilibrium—but with
a higher built-in inflation rate
31
Long-Run Equilibrium
• In short-run, Fed can move along Phillips curve
– Exploiting trade-off between unemployment and
inflation
– But in long-run—once public expectations of inflation
adjust to the new reality—built-in inflation rate will
change, and Phillips curve will shift
• In short-run, there is a trade-off between inflation
and unemployment
– Fed can choose lower unemployment at cost of higher
inflation or lower inflation at cost of higher
unemployment
– But in long-run there is no such trade-off
• Since unemployment always returns to its natural rate
32
The Long-Run Phillips Curve
• In long-run monetary policy can change rate of
inflation but not rate of unemployment
• Vertical line is economy’s long-run Phillips curve
– Tells us combinations of unemployment and inflation
that Fed can choose in long-run
• Long-run Phillips curve is a vertical line at the
natural rate of unemployment
– Fed can select any point along this line in long-run
• By using monetary policy to speed or slow rate at which AD
curve shifts rightward
33
Why the Fed Allows Ongoing
Inflation
• Since Fed can choose any rate of inflation it wants, and
since inflation is costly to society
– We might think Fed would aim for an inflation rate of zero
– Why doesn’t Fed eliminate inflation from economy entirely?
• One reason is a widespread belief that Consumer Price
Index (CPI) and other measures of inflation actually
overstate true rate of inflation
– If Fed forced the measured rate of inflation down to zero
• Result would be an actual rate of inflation that was negative deflation
• Some economists have offered another explanation for
Fed’s behavior
– Low, stable inflation makes labor market work more smoothly
• Fed has tolerated measured inflation at 2 to 3% per year
– Because it knows that rate of inflation is lower and
– Because low rates of inflation may help labor markets adjust more
easily
34
Using the Theory: Challenges For
Monetary Policy
• Might almost conclude that monetary policy is akin to
operating a giant machine
– And policy making might appear rather uncontroversial
• But truth is very much the opposite
– Fed faces frequent criticism from members of Congress, business
community, media, and some academic economists
• Not just over its policy choices, but also the way it arrives at them
– Fed—rather than operating a well-understood machine—must
conduct monetary policy with highly imperfect information about
economy’s course and precisely how Fed policies will alter it
– In early 2000s, Fed found itself facing a new economic challenge
• Possibility of deflation
– Requiring Fed to develop some new, untested tools for monetary
policy…just in case
35
Using the Theory: Information
Problems
• Federal Reserve has hundreds of economists
carrying out research and gathering data
– To improve its understanding of how economy works,
and how monetary policy affects economy
• Research at Fed is widely respected
– But because economy is complex and constantly
changing, serious gaps remain
• Time lag before monetary policy affects economy
• Knowledge of economy’s potential output
36
Using the Theory: Uncertain and
Changing Time Lags
• Monetary policy works with a time lag
– Even after a rise in the interest rate, business firms will
likely continue to build new plants and new homes
they’ve already started constructing
– Same applies in other direction
• Time lag in effectiveness of monetary policy can
have serious consequences
• Even worse, time lag before monetary policy
affects prices and output can change over the
years
– Just when Fed may think it has mastered the rules of
the game, the rules change
37
The Natural Rate of Unemployment
• In Phillips curve diagram, we’ve assumed that economy’s natural rate
of unemployment is known and remains constant
– Signified by vertical long-run Phillips curve at some value UU
• Many economists believe that today natural rate is between 4.5 and 5
%, but no one is really sure
• What is the problem?
– In order to achieve its twin goals of full employment and a stable, low
inflation rate
• Fed tries to maintain unemployment rate as close to natural rate as possible
– If estimate of natural rate is wrong, it may believe it has succeeded when, in fact, it
has not
• Trial and error can help Fed determine true natural rate
– But trial and error works best when there is continual and rapid feedback
• Estimating natural rate of unemployment is made even more difficult
because economy is constantly buffeted by shocks of one kind or
another
– This information is difficult to sort out
• Although Fed has become increasingly sophisticated in its efforts to do so
38
Rules Versus Discretion and the
“Taylor Rule”
• Over last several decades, Federal Reserve has
formulated monetary policy using discretion
– Responding to demand and supply shocks in the way
that Fed officials thought best at the time
• Should Federal Reserve have complete discretion
to change its interest rate target in response to
demand and supply shocks as it sees fit?
– Or should it stick to rules or guidelines in making
monetary policy
• Rules that it announces in advance, with a justification required
for any departure?
• Currently, most often-discussed rule is Taylor rule
– Originally proposed in 1993 by economist John Taylor
(currently Undersecretary of Treasury for International
Affairs)
39
Rules Versus Discretion and the
“Taylor Rule”
• According to Taylor rule, Fed would announce a
target for inflation rate, and another target for real
GDP (based on its estimate of GDP in that period)
– Then Fed would obligate itself to change its interest
rate target by some pre-determined amount for each
percentage point that either output or inflation deviated
from its respective target
• What would be advantage of such a rule?
– By committing Federal Reserve to respond to the first
signs that economy is heading toward a boom
• Fed lets the public know that it will not allow the economy to
continue overheating
– Thus discourages formation of inflationary expectations
40
Rules Versus Discretion and the
“Taylor Rule”
• Taylor rule would give Fed ammunition to
fight inflation with a higher interest rate
– Even when doing so might prove unpopular at
the time
• Taylor rule is controversial
– Opponents argue
• Implies more advanced knowledge about the
economy—and what an appropriate future response
should be—than is realistically possible
• Fed’s behavior, under Alan Greenspan, has
conformed closely to specific numerical rule that
Taylor has proposed over much of the recent past
41
Deflation
• During first four years of Great Depression, price levels fell
an average of 10% per year
– Very serious episode of deflation
• Why does deflation create difficulties for monetary policy?
– Problem for Fed is that nominal interest rate cannot go below zero
• Recall relationship between real and nominal interest rates
– Real interest rate = Nominal interest rate – Rate of inflation
• an also write this in terms of real interest rate that people
expect to pay (or receive) on a loan
– Expected real interest rate = Nominal interest rate – Expected Rate of inflation
• Relationship tells us that when expected inflation rate is positive, real
interest rate will be less than nominal rate
• But suppose there is deflation—a negative rate of
inflation—and suppose that people begin to expect
continuing deflation
– Equation tells us that expected real interest rate will be higher than
nominal interest rate
42
Deflation
• Ongoing expected deflation puts a positive floor under
expected real interest rate
– Once this floor is reached, expected real interest rate cannot
decrease any further during decreases in the nominal rate
• Potentially limiting Fed’s ability to raise aggregate expenditure and
output with monetary policy
• In 2003—with annual federal funds rate set at 1% and
annual inflation running at about 2%
– Real federal funds rate was –1%
• Fear was this could create a dangerous vicious circle
– Decreased spending—a negative demand shock—would further
decrease the inflation rate (a greater deflation rate)
• Which in turn would raise real interest rate even further
43
Deflation
• Fed officials were very much aware of this problem
– In early 2000s they began to plan for contingency of deflation
– While deflation of 5 or 10% a year would be a serious threat
• A modest deflation rate was unlikely to create a downward spiral for economy
– Fed announced that it was prepared to change the way it conducts
monetary policy should need arise
• Instead of limiting its open market operations to injecting reserves into federal
funds market
– It was prepared to start buying long term government bonds
– Fed had one other tool
• Ability to influence expectations
• By announcing believable policies designed to raise inflation to a modest,
positive level
– Fed could create positive inflationary expectations even in the midst of deflation
– Most economists believe that Fed would be able to convince the public, should the
need arise
– Even if all monetary policy tools were unable to stimulate spending, fiscal
policy could be used
• Government could increase purchases itself, or reduce taxes even further to
raise disposable income
44
Deflation
• Conducting monetary policy is not easy
– Fed carries out research and gathers data to improve
its information
– Effort seemed to have paid off during decade leading
up to 2001
• Will Fed continue to be as successful as it has
been in recent years?
– Difficult to say
45