Inflation and
Monetary Policy
© 2003 South-Western/Thomson Learning
The Objectives
of Monetary Policy
•Low, Stable Inflation
•Full Employment
Full Employment
Natural Rate of Unemployment
The unemployment rate when there
is no cyclical unemployment.
Full Employment
When the unemployment rate is
below the natural rate, GDP is greater
than potential output.
The economy’s self-correcting
mechanism will then create inflation.
Full Employment
When the unemployment rate is
above the natural rate, GDP is below
potential output.
The self-correcting mechanism will
then put downward pressure on the
price level.
The Fed’s Performance
•The Fed has had a good - and
improving - record:
•The inflation rate has been kept low
and relatively stable, and
•unemployment has been near most
estimates of the natural rate.
The Fed’s Performance
(a)
Inflation
Rate
In the 1970s and
early 1980s there
were periods of
high inflation . . .
12%
but the inflation
rate dropped
during the
1980s . . .
10%
8%
6%
and it dropped
still lower in the
1990s and early
2000s.
4%
2%
0
1955
1965
1975
1985
1995 2001
Year
(b)
Unemployment
Rate
The unemployment
rate was particularly
high during the
early 1980s . . .
10%
but it fell
dramatically during
the 1990s . . .
8%
then began to
rise again in
2001.
6%
4%
2%
1955
1965
1975
1985
1995 2001
Year
Federal Reserve Policy: Theory
and Practice
•Responding to Changes in Money
Demand
•Responding to Spending Shocks
•Responding to Supply Shocks
Federal Reserve Policy: Theory
and Practice
Passive Monetary Policy
When the Fed keeps the money
supply constant regardless of shocks
to the economy
Federal Reserve Policy: Theory
and Practice
Active Monetary Policy
When the Fed changes the money
supply to achieve some objective
Responding to Changes in
Money Demand
(a)
Interest
Rate (%)
(b)
s
Price
Level
M1
AS
r2
r1
F
E
E
P1
d
M2
P2
F
AD1
d
M1
AD2
Money
Y2
YFE
Real GDP
Responding to Changes in
Money Demand
Interest Rate Target
The interest rate the Federal Reserve
aims to achieve by adjusting the
money supply
Keeping the Interest Rate on
Target
Fed sets an interest rate target
• changes the money supply as
needed to maintain the target
• can achieve its goals of price
stability and full employment
simultaneously
Responding to Spending Shocks
(a)
Interest
Rate (%)
M
(b)
Price
Level
s
Long-Run AS
AS
r2
F
K
P5
r1
E
d
M2
d
P4
P3
P2
P1
J
H
F
AD3
E
M1
AD 2
AD 1
Money
YFE Y2
Real GDP
Responding to Spending Shocks
(a)
Interest
Rate (%)
s
M2
(b)
s
Price
Level
M1
AS
r3
r2
r1
H
F
P2
F
E
P1
E
AD2
d
M2
d
AD1
M1
Money
YFE
Y2
Real GDP
Responding to Spending Shocks
To maintain full employment and price
stability after a spending shock, the Fed
must change its interest rate target:
•A positive spending shock requires an
increase in the target.
•A negative spending shock requires a
decrease in the target.
Interest Rate Target and
Financial Markets
The stock and bond markets move in the
opposite direction to the Fed’s interest
rate target:
• when the Fed raises its target, stock and
bond prices fall
• when it lowers its target, stock and bond
prices rise
Interest Rate Target and
Financial Markets
Good news about the economy
sometimes leads to expectations that the
Fed - fearing inflation - will raise its
interest rate target.
This is why good economic news
sometimes causes stock and bond prices
to fall.
Interest Rate Target and
Financial Markets
Bad news about the economy sometimes
leads to expectations that the Fed fearing recession - will lower its interest
rate target.
This is why bad economic news
sometimes causes stock and bond prices
to rise.
Responding to Supply Shocks
Price
Level
AS2
AS1
P3
P2
P1
R
T
V
E
ADno recession
AD1
ADno inflation
Y3 Y2 YFE
Real GDP
Responding to Supply Shocks
An adverse supply shock presents the
Fed with a short-run trade-off:
• 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.
Hawk and Dove Policies
Hawk: The Fed should choose a hawkish
policy if it cares more about price stability.
Dove: The Fed should choose a dovish policy
if it cares more about the stability of output
and employment.
Expectations and
Ongoing Inflation
•How Ongoing Inflation Arises
•Ongoing Inflation and the Phillips
Curve
•Why the Fed Allows Ongoing
Inflation
Ongoing Inflation
When inflation continues for some
time, the public develops
expectations that the inflation rate in
the future will be similar to the
inflation rates of the recent past.
Ongoing Inflation
A continuing, stable rate of
inflation gets built into the
economy:
• The built-in rate is usually the rate
that has existed for the past few
years.
Ongoing Inflation
Price
Level
AS 3
AS 2
AS1
P3
P2
P1
AD 3
AD 2
AD 1
YFE
Real GDP
Ongoing Inflation
In an economy with built-in inflation, the
AS curve will shift upward each year, even
when output is at full employment and
unemployment is at its natural rate.
The upward shift of the AS curve will
equal the built-in rate of inflation.
Ongoing Inflation
In the short run, the Fed can bring
down the rate of inflation by
reducing the rightward shift of the
AD curve, but only at the cost of
creating a recession.
Ongoing Inflation and the
Phillips Curve
Phillips Curve
A curve indicating the Fed’s choice
between inflation and unemployment
in the short run
The Phillips Curve
Inflation
Rate
6%
E
F
3%
PCbuilt-in inflation
= 6%
UN
U1
Unemployment
Rate
The Phillips Curve
In the short run, the Fed can move along the
Phillips curve by adjusting the rate at which
the AD curve shifts rightward.
When the Fed moves the economy downward
and rightward along the Phillips curve, the
unemployment rate increases, and the
inflation rate decreases.
The Phillips Curve
Inflation
Rate
9%
Long Run
Phillips Curve
H
J
E
6%
PC
G
3%
built-in inflation = 9%
F
PC built-in inflation = 6%
PC built-in inflation = 3%
U2
UN
U1
Unemployment
Rate
The Phillips Curve
In the long run, a decrease in the actual
inflation rate leads to a lower built-in
inflation rate, and the Phillips curve
shifts downward.
The Long-Run Phillips Curve
Long-Run Phillips Curve
A vertical line indicating that in the long
run, unemployment must equal its
natural rate, regardless of the rate of
inflation
The Long-Run Phillips Curve
In the short run, there is a trade-off
between inflation and unemployment:
• lower unemployment at the cost of higher
inflation, or
• lower inflation at the cost of higher
unemployment.
But in the long run, since unemployment
always returns to its natural rate, there is
no such trade-off.
The Long-Run Phillips Curve
In the long run, monetary policy can
change the rate of inflation, but not
the rate of unemployment.
The Long-Run Phillips Curve
The Fed can select any point along the
line of the Phillips curve in the long run
by using monetary policy to speed or
slow the rate at which the AD curve shifts
rightward.
Why the Fed Allows Ongoing
Inflation
The Fed has tolerated measured inflation
of 2 to 3 percent per year because
• it knows that the true rate of inflation is
lower
• low rates of inflation may help labor
markets adjust more easily
• there is not much payoff to lowering
inflation further