Chapter 16 Inflation and Monetary Policy The Objectives of Monetary Policy rate low and stable The Fed s objective in the 1950s and 1960s changed to keeping the interest Now the Fed is responsible for achieving a low stable rate of inflation as well as full employment of the labor force called the dual mandate of the Fed Low Stable Inflation When the inflation rate is high society uses up resources coping with it resources that could have been used to produce goods and services o Labor to update prices at stores and factories o Additional time spent by households and businesses to manage their wealth protect it from a loss of purchasing power Fed also tries to keep inflation rate stable o Unstable is a problem often turns out higher or lower than people expected o Unstable adds to risk of lending and borrowing and interferes with long run financial planning Full Employment Cyclical unemployment is a macro problem o Occurs during a recession o Full employment the absence of cyclical unemployment Fed is concerned about cyclical unemployment bc o Opportunity cost the output that the unemployed could have produced if they were working o Social failure can cause significant hardship If the unemployment rate falls too low GDP rises beyond its potential full employment level o Causes the economy s self correcting mechanism to kick in the AS curve shifts upward increasing the price level o Fed cannot keep the economy operating beyond full employment for more than a short time o Long run attempts to push the economy too hard would cerate more inflation The Natural Rate of Unemployment 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 put downward pressure on the price level Natural rate 5 The Fed s Performance Over the past two decades the inflation rate has averaged about 2 5 Federal Reserve Policy Theory and Practice Fed must constantly respond to macro events with 2 goals in mind low inflation and full employment Responses that maintain full employment will worsen inflation and responses that alleviate inflation will create more unemployment Two assumptions o The Fed s goal is an inflation rate of 0 o Over the long run the Fed succeeds in achieving this goal Responding to Demand Shocks Positive demand shock can come from fiscal policy increase in govt purchases or tax cut or from the private sector increases in autonomous consumption investment or net exports 3 possible responses maintaining the money supply maintaining the interest rate and neutralizing the shock Hypothetical Response Constant Money Supply BAD Positive demand shock sets off the multiplier process o AD curve shifts rightward Rise in GDP causes a movement along the AS curve and the price level rises o Rise in price level shifts money demand curve right driving up the interest rate which crowds out some consumption and investment spending so that GDP does not rise by as much as it otherwise would Fed would NOT want to respond to a positive demand shock by holding the money supply constant output would rise above potential bringing the unemployment rate below its natural rate o Price level would also rise If a fully employed economy experiences a positive demand shock and 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 Hypothetical Response Constant Interest Rate BAD Once the Fed sets its target it then adjusts the money supply as necessary to hit it Constant interest rate AD curve shifts right interest rate rises Fed increases money supply shifting curve right will maintain the interest rate at target If a fully employed economy experiences a positive demand shock a constant interest rate creates an even greater overshooting of potential output than a constant money supply The result is an even greater rise in the price level Best Response Neutralization GOOD Fed prevents any shift in the AD curve at all completely neutralize the demand shock An increase in spending shifts the AD curve rightward Fed creates complete crowding out o Raises its interest rate target by just enough to make spending fall as much as it initially rose from the demand shock o Total spending remains unchanged and AD curve does not shift at all o AD curve first shifts rightward then leftward back to its original position To neutralize the Fed must raise its interest rate higher than before o Supply curve shifts left back to original price level Negative demand shock Fed should lower interest rate target by increasing the money supply o Lower interest rate will stimulate additional consumption and investment spending and can prevent the AD curve from shifting leftward To maintain full employment and price stability after a demand shock the Fed must change its interest rate target A positive demand shock requires an increase in the target a negative demand shock requires a decrease in the target If the Fed observes that the economy is overheating it will raise its target higher interest rate to prevent shift of AD curve right If the Fed observes the economy is sluggish it will lower target o Lowering target and trying to shift AD curve right Responding to Supply Shocks Negative supply shocks present the Fed with a dilemma if the Fed tries to preserve price stability it will worsen unemployment o If it tries to maintain high employment it will worsen inflation Fed can prevent inflation entirely by decreasing the money supply shifting the AD curve leftward Fed can prevent any fall in output by increasing the money supply and shifting the AD curve rightward causes more inflation Dilemma a negative supply shock presents the Fed with a short run tradeoff It can limit the recession but only at the cost of more inflation and it can limit inflation but only at the cost of a deeper recession o Inflation hawks lean in the direction of price stability and are willing to tolerate more unemployment in order to achieve it o Inflation doves lean in the direction of a milder recession and are more willing to tolerate the cost of higher inflation Choosing between Hawk and Dove Policies Hawk policy maintains more stability in the price level but less stability in Dove policy maintains more stability in output and less
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