Ch 16 Inflation and Monetary Policy I The Objectives of Monetary Policy i Dual Mandate A Low Stable Inflation B Full Employment Why is low rate inflation important When inflation rate is high society uses up resources in order to deal with it resources that could have been used to produce G S Fed tries to keep inflation rate low and stable Unstable inflation adds to the risk of lending borrowing and interferes with long run financial planning fed chooses policies with costs of inflation in mind Inflation very unpopular with the public Full Employment unemployment is at normal levels Frictional unemployment Structural unemployment Cyclical unemployment occurs during recession in which millions of workers lose their jobs and remain unemployed as they seek new ones full employment the absence of cyclical unemployment when economy achieves full employment macroeconomic policy has done all it can do Fed concerned with cyclical unemployment for 2 reasons i Opportunity costs the output the unemployment could have produced if they were working 1 By maintaining full employment fed can help society avoid this cost ii Cyclical unemployment represents social failure 1 In recession ppl who have the right skills and who could be working actually lose their jobs 2 Excess unemployment caused by recession is a partial breakdown of the system 3 The economy is not doing what it should do provide jobs for those who want to work and have the needed skills Why should fed try to eliminate cyclical unemployment Shouldn t the fed try to fix the lowest possible unemployment rate i No b c if the unemployment rate falls too low GDP rises beyond its potential full employment level ii This causes the economy s self correcting mechanism to kick in AS curve shifts upward increasing price level iii Unemployment that is too low compromises the Fed s other chief goal by creating inflation 1 The natural rate of Unemployment Ch 16 Inflation and Monetary Policy i Natural Rate of Unemployment the unemployment rate at which GDP is at its full employment level with no cyclical unemployment ii 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 When the unemployment rate is above the natural rate GDP is below potential output The self correcting mechanism will then out downward pressure on the price level iii The natural unemployment rate determined by how frequently workers move from job to job how efficiently the unemployed can search for jobs and firms can search for new workers and how well the skills of the unemployed match the skills needed by employers iv Natural rate can change with any of the underlying conditions and can be influenced by govt policies v Stimulating the economy with fiscal or monetary policy may change actual unemployment by will not change the natural rate itself vi And pushing unemployment below the natural rate vii Natural rate of unemployment goalpost for fed Tells us would cause inflation where the fed is aiming C The Fed s Performance Federal Reserve Policy Theory and Practice II Assumptions i The fed s goal is an inflation rate of zero ii Over the long run the fed succeeds in achieving this goal A Responding to Demand Shocks Demand Shock a change in spending that shifts the economy s aggregate demand AD curve Suppose economy is operating at its potential output then it is hit w a positive demand shock o Shock might come from fiscal policy increase in govt purchases or tax cut o Or come from the private sector increase in autonomous consumption investment or net exports How should fed respond Possible responses o Maintaining the money supply o Maintain the interest rate o Neutralizing the shock Ch 16 Inflation and Monetary Policy 1 Hypothetical Response Constant Money Supply o economy initially operating at full employment o Panel a shows money market with equilibrium o Panel b shows aggregate deamand and aggregate interest rate at 5 supply diagram Equilibrium point E w price level of 100 and out put of 10 trillion the assumed full emploument level o Points A and E represent the long run equilibrium in economy w output at its potential and therefore unemployment at its natural rate economy at rest o Then positive demand shock increase in spending hits economy setting off multiplier process o AD curve shifts right ward from AD1 to AD2 o At every price level the equilibrium GDP is greater than before o The rise in GDP causes movement along AS curve and price level rises o In money market Panel a the rise in price level shifts the money demand curve rightward driving the interest rate up to 7 o This crowds out some consumption and investment spending so that GDP does not rise by as much as it otherwise would But it still rises o In panel b end up at point H with price level rising to 110 and real GDP rising to 11 5 trillion o Fed would not want to respond to a positive demand shock by holding the money supply constant o Output would rise above potential bringing unemployment rate below its natural rate Ch 16 Inflation and Monetary Policy price level would rise as well in long run the price level would rise further as the self correcting mechanism returned the economy to full employment by shifting the AS curve upward o If a fully employed economy experiences a positive demand shock the Fed responds by holding the money supply constant output will overshoot its potential The price level will rise in the short run and rise further in the long run o B c we are assuming the Fed s goal is zero inflation holding the money supply constant would not be a good response 2 Hypothetical Response Constant Interest Rate o In practice Fed conducts monetary policy by setting a target for the federal funds rate o In normal times when different interest rates in the economy move up and down together targeting the federal funds rate is equivalent to targeting the average level of interest rate in the economy o What would happen if the fed in response to a positive demand shock chose to maintain a constant interest rate target o In Panel a the interest rate is initially at its target rate of 5 o In panel b the economy is at full employment with output of 10 trillion o When the positive demand shock hits the AD curve begins to shift rightward in panel b Ch 16 Inflation and Monetary Policy o AD2 shows where the AD curve would be if the Fed did not change the money supply o But this time as the money demand
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