CHAPTER 24:
Monetary Policy Theory
Instructor: Prof. & Dr. Tran Ngoc Tho
Members of group:
- Cao Thị Ánh Tuyết
- Vũ Thanh Tùng
CHAPTER 24:
Monetary Policy Theory
RESPONSE OF MONETARY POLICY TO SHOCKS
HOW ACTIVELY SHOULD POLICYMAKERS TRY TO STABILIZE
ECONOMIC ACTIVITY?
INFLATION: ALWAYS AND EVERYWHERE A MONETARY PHENOMENON
CAUSES OF INFLATIONARY MONETARY POLICY
RESPONSE OF MONETARY POLICY TO SHOCKS
The central goal of central banks
•
Price stability: The central bank pursues price stability is that monetary policy should try to minimize the difference between inflation
T
and the inflation target (π - π ) – inflation gap.
•
Economic activity stability: The economic activity can be sustained only at potential output, this objective of monetary policy can be
P
described as saying that monetary policymakers want to have aggregate output close to its potential level, Y . The central bank want to
P
minimize the difference between aggregate output and potential output (Y − Y ) – output gap.
RESPONSE OF MONETARY POLICY TO SHOCKS
•
Demand Shocks
•
Permanent Supply Shocks
•
Temporary Supply Shocks
RESPONSE OF MONETARY POLICY TO SHOCKS
Response to an Aggregate Demand Shock
LRAS
We begin by considering the effects of an aggregate demand
Inflation Rate, π
shock, such as the disruption to financial markets starting in
AS1
August 2007 that increased financial frictions and caused both
consumer and business spending to fall. The economy is
initially at point 1, where output is at Y
P
T
π
T
1
and inflation is at π .
AD1
AD2
Y
The negative demand shock decreases aggregate demand, shifting
AD1 to the left to AD2.
P
Aggregate Output, Y
RESPONSE OF MONETARY POLICY TO SHOCKS
Response to an Aggregate Demand Shock
LRAS
No Policy Response
Inflation Rate, π
AS1
Because the central bank does not respond by changing the
autonomous component of monetary policy, the aggregate
demand curve remains at AD2 and so the economy goes to
the intersection of AS1 and AD2. Here, aggregate output
P
falls to Y2, below potential output Y , and inflation falls to
T.
π2, below the inflation target of π
AS3
π
T
1
π2
2
π3
3
AD1
AD2
Y2
Y
P
Aggregate Output, Y
The short run aggregate supply curve will shift down and to the right to AS3 .Output will again be back at its potential level, while inflation will
fall to a lower level of π3.
RESPONSE OF MONETARY POLICY TO SHOCKS
Response to an Aggregate Demand Shock
LRAS
Policy Stabilizes Economic Activity and Inflation in the Short
Inflation Rate, π
Run
The central bank uses autonomously easing monetary policy by
cutting the real interest rate at any given inflation rate. The
AS1
π
T
1,3
π2
2
aggregate demand curve shifts from AD2 back to AD1 and the
economy returns to point 1.
AD1
AD2
Y2
Y
P
Aggregate Output, Y
In the case of aggregate demand shocks, there is no tradeoff between the pursuit of price stability and economic activity stability. A focus on
stabilizing inflation leads to exactly the right monetary policy response to stabilize economic activity. No conflict exists between the dual
objectives of stabilizing inflation and economic activity – Olivier Blanchard.
RESPONSE OF MONETARY POLICY TO SHOCKS
Response to a permanent Supply Shock
Inflation Rate, π
LRAS3
LRAS1
Suppose the economy suffers a permanent negative supply
AS2
shock because an increase in regulations permanently reduces
AS1
the level of potential output.
1
π
T
AD1
P
P
Potential output falls from Y 1 to Y 3, and the long-run
aggregate supply curve shifts leftward from LRAS1 to
LRAS3
The permanent supply shock triggers a price shock that
shifts the short-run aggregate supply curve upward from
AS1 to AS2.
P
Y 3
P
Y 1
Aggregate Output, Y
RESPONSE OF MONETARY POLICY TO SHOCKS
Response to a permanent Supply Shock
Inflation Rate, π
LRAS1
LRAS3
AS3
No Policy Response
AS2
3
If
policymakers leave autonomous monetary policy
unchanged, the economy will move to point 2, with inflation
rising to π2 and output falling to Y 2.
AS1
π3
2
π2
π
1
T
AD1
P
Y 3
Y2
P
Y 1
Aggregate Output, Y
P
Because this level of output is still higher than potential output, Y 3 , the short-run aggregate supply curve keeps shifting up and to the left
until it reaches AS 3, where it intersects AD 1 on LRAS 3. The economy moves to point 3, eliminating the output gap but leaving inflation
P
higher at π3 and output lower at Y 3.
RESPONSE OF MONETARY POLICY TO SHOCKS
Response to a permanent Supply Shock
FIGURE 4
Inflation Rate, π
LRAS3
LRAS1
Policy Stabilizes Inflation
AS3
The
monetary
authorities
would
autonomously
tighten
monetary policy by increasing the real interest rate at any given
inflation rate, thus causing investment spending to fall and
AS1
2
π2
π
T
3
1
lowering aggregate demand at any given inflation rate. The
economy thus goes to point 3, where the output gap is zero and
T
inflation is at the target level of π .
AD1
AD2
P
Y 3
P
Y 1
Aggregate Output, Y
Here again, keeping the inflation gap at zero leads to a zero output gap, so stabilizing inflation has stabilized economic activity. There is no
tradeoff between the dual objectives of stabilizing inflation and economic activity.
RESPONSE OF MONETARY POLICY TO SHOCKS
Response to a temporary Supply Shock
When a supply shock is temporary, such as when the price of
FIGURE 5
LRAS
Inflation Rate, π
AS2
oil surges because of political unrest in the Middle East or
because of an act of god, such as a devastating hurricane in
Florida, the divine coincidence does not always hold.
Policymakers face a short-run tradeoff between stabilizing
AS1
2
π2
π
T
1
inflation and economic activity.
AD1
Y2
P
Y
Aggregate Output, Y
The negative supply shock – a rise in the price of oil, shifts
the short-run aggregate supply curve up and to the left from
Policymakers can respond to the temporary supply shock in
AS1 to AS2 . The economy moves to point 2, with inflation
three possible ways.
rising to π2 and output falling to Y2.
RESPONSE OF MONETARY POLICY TO SHOCKS
Response to a temporary Supply Shock
No Policy Response
FIGURE 5
LRAS
Inflation Rate, π
P
Since aggregate output is less than potential output Y ,
AS2
eventually the short-run aggregate supply curve will shift back
AS1
down to the right, returning to AS 1. The economy will return to
π2
point 1 in Figure 5 and close both the output and inflation gaps,
π
2
T
1
P
T
as output and inflation return to the initial levels of Y and π .
Both inflation and economic activity stabilize over time.
AD1
Y2
P
Y
Aggregate Output, Y
In the long run, there is no tradeoff between the two objectives, and the divine coincidence holds. While we wait for the long run,
however, the economy will undergo a painful period of reduced output and higher inflation rates. This opens the door to monetary policy to
try to stabilize economic activity or inflation in the short run.
RESPONSE OF MONETARY POLICY TO SHOCKS
Response to a temporary Supply Shock
FIGURE 6
LRAS1
Inflation Rate, π
Policy Stabilizes Inflation in the Short Run
AS2
To keep inflation at the target level of in π
T
AS1
the short run by autonomously
tightening monetary policy and raising the real interest rate at any given inflation rate
Investment spending and aggregate demand to fall at each inflation rate shifting
π2
π
2
T
3
1
the aggregate demand curve to the left (AD1 AD3).
AD1
AD3
Y3
Y2
Y
P
Aggregate Output, Y
Because output is below potential at point 3, the slack in the economy shifts the short run aggregate supply curve back down to AS1. To keep the inflation rate at
T
π , the monetary authorities will need to move the short-run aggregate demand curve back to AD1 by reversing the autonomous tightening and eventually, the
economy will return to point 1.
P
As Figure 6 illustrates, stabilizing inflation reduces aggregate output to Y3 in the short run, and only over time will output return to potential output at Y .
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.
RESPONSE OF MONETARY POLICY TO SHOCKS
Response to a temporary Supply Shock
FIGURE 7
LRAS
Inflation Rate, π
Policy Stabilizes Economic Activity in the Short Run
AS2
AS1
To stabilize economic activity rather than inflation in the short
run by increasing aggregate demand (autonomously ease
monetary policy). They would shift the aggregate demand
π3
π2
π
3
2
T
1
curve to the right to AD3, where it intersects the short-run
aggregate
AD3
supply curve AS2 and the long-run aggregate
supply at point 3.
AD1
Y2
Y
P
Aggregate Output, Y
T
Monetary policy has stabilized economic activity. However, inflation has risen to π 3, which is greater than π , so inflation has not been
stabilized. Stabilizing economic activity in response to a temporary supply shock results in a rise in inflation, so inflation has not been
stabilized.
RESPONSE OF MONETARY POLICY TO SHOCKS
The relationship Between Stabilizing inflation and Stabilizing economic activity
•
If most shocks to the 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.
•
If temporary supply shocks are more common, then a central bank must choose between the two stabilization objectives in the short run.
•
In the long run there is no conflict between stabilizing inflation and economic activity in response to shocks.
HOW ACTIVELY SHOULD POLICYMAKERS TRY TO STABILIZE ECONOMIC ACTIVITY?
All economists have similar policy goals (to promote high employment and price stability), yet they often disagree on the best approach to achieve
those goals. Suppose policymakers confront an economy that has high unemployment resulting from a negative demand or supply shock that has
reduced aggregate output.
Nonactivists
Activists
- Wages and prices are very flexible, so the self-correcting mechanism is very
- They regard the self-correcting mechanism through wage and
rapid.
price adjustment as very slow because wages and prices are sticky.
- They thus believe government action is unnecessary to eliminate unemployment.
- They therefore see the need for the government to pursue active policy
to eliminate high unemployment when it develops.
HOW ACTIVELY SHOULD POLICYMAKERS TRY TO STABILIZE ECONOMIC ACTIVITY?
Lags and policy implementation
If policymakers could shift the aggregate demand curve instantaneously, activist policies could be used to immediately move the economy to the fullemployment level. However, several types of lags prevent this immediate shift from occurring:
1. The data lag is the time it takes for policymakers to obtain data indicating what is happening in the economy.
2. The recognition lag is the time it takes for policymakers to be sure of what the data are signaling about the future course of the economy.
3. The legislative lag represents the time it takes to pass legislation to implement a particular policy. The legislative lag does not exist for most monetary policy
actions, such as lowering interest rates. It is, however, important for the implementation of fiscal policy, when it can sometimes take six months to a year to pass
legislation to change taxes or government purchases.
HOW ACTIVELY SHOULD POLICYMAKERS TRY TO STABILIZE ECONOMIC ACTIVITY?
Lags and policy implementation
4. The implementation lag is the time it takes for policymakers to change policy instruments once they have decided on the new policy. Again, this lag is less
important for the conduct of monetary policy than fiscal policy because the Federal Reserve can immediately change its policy interest rate. Actually
implementing fiscal policy may take substantial time.
5. The effectiveness lag is the time it takes for the policy actually to have an impact on the economy. The effectiveness lag is both long (often a year or longer)
and variable (that is, there is substantial uncertainty about how long this lag is).
The existence of all these lags makes the policymakers’ job far more difficult and therefore weakens the case for activism. When unemployment is high,
activist policy to shift the aggregate demand curve rightward to restore the economy to full employment may not produce desirable outcomes. Indeed, if
the policy lags described above are very long, then by the time the aggregate demand curve shifts to the right, the self-correcting mechanism may have
already returned the economy to full employment, so when the activist policy kicks in it may cause output to rise above potential, leading to a rise in
inflation. In the situation where policy lags are longer than the time it takes the self-correcting mechanism to work, a policy of nonactivism may
produce better outcomes.
INFLATION: ALWAYS AND EVERYWHERE A MONETARY PHENOMENON
Inflation Rate, π
LRAS
P
The economy is at point 1, with aggregate output at potential output Y and inflation
T
at an initial inflation target of π 1.
AS3
AS1
T
Suppose the central bank chooses to raise it to π 3. It eases monetary policy
T
π 3
π2
autonomously by lowering the real interest rate at any given inflation rate,
T
π 1
3
2
1
thereby increasing investment spending and aggregate demand. The
aggregate demand curve shifts to AD3. The economy would then move to
AD3
point 2 at the intersection of AD3 and AS1, with inflation rising to π2.
AD1
Y
P
Y2
Aggregate Output, Y
1.The monetary authorities can target any inflation rate in the long run
P
Because Y2 > Y , the short-run aggregate supply curve would shift up and
to the left, eventually stopping at AS3, with the economy moving to point 3,
T
where inflation is at the higher target level of π 3 and the output gap is
back at zero
with autonomous monetary policy adjustments.
2. Potential output—and therefore the quantity of aggregate output produced in the
long run—is independent of monetary policy.
CAUSES OF INFLATIONARY MONETARY POLICY
High employment targets and inflation
The primary goal of most governments is high employment, and the pursuit of this goal can bring high inflation. Two types of inflation can result from an
activist stabilization policy to promote high employment:
1. Cost-push inflation results either from a temporary negative supply shock or a push by workers for wage hikes beyond what productivity gains can justify.
2. Demand-pull inflation results from policymakers pursuing policies that increase aggregate demand.
We
will
now
use
aggregate
high employment target on both types of inflation.
demand
and
supply
analysis
to
examine
the
effect
of
a
CAUSES OF INFLATIONARY MONETARY POLICY
High employment targets and inflation
Cost-Push Inflation
FIGURE 9
LRAS
Inflation Rate, π
Consider the economy, which is initially at point 1, the intersection
of the aggregate demand curve AD1 and the short-run aggregate
AS2
supply curve AS1.
AS1
Suppose workers succeed in pushing for higher wages or they expect
inflation to be high and wish their wages to keep up with it. This cost-
π2'
push shock, which acts like a temporary negative supply shock, raises
π1
2’
1
the inflation rate and shifts the short-run aggregate supply curve up
and to the left to AS2.
AD1
Y’
Y
P
Aggregate Output, Y
If the central bank takes no action to change the equilibrium interest rate and the monetary policy curve remains unchanged. The economy would move to point 2’
at the intersection of the new short-run aggregate supply curve AS2 and the aggregate demand curve AD1. Output would decline to Y’ below potential output and
the inflation rate would rise to π2, leading to an increase in unemployment.
CAUSES OF INFLATIONARY MONETARY POLICY
High employment targets and inflation
Cost-Push Inflation
Activist policymakers with a high employment target would implement
policies, such as a cut in taxes, an increase in government purchases, or
FIGURE 9
LRAS
Inflation Rate, π
AS4
AS3
an autonomous easing of monetary policy, to increase aggregate
demand. These policies would shift the aggregate demand curve to AD2
quickly returning the economy to potential output at point 2 and
increasing the inflation rate to π2.
π4
AS2
4
4’
π3
AS1
3
3’
2
π2
π2'
2’
π1
AD4
1
AD3
AD2
AD1
The workers’ success might encourage them to seek even higher wages. In
Y’
Y
P
Aggregate Output, Y
addition, other workers might now realize that their wages have fallen relative to
their fellow workers, leading them to seek wage increases. Another temporary
Activist policies once again to shift the aggregate demand curve rightward
negative supply shock would occur that would cause the short-run aggregate
to AD3 and return the economy to full employment at a higher inflation rate
supply curve to shift up and to the left again, to AS3. Unemployment develops
of π3. If this process continues, the result will be a continuing increase in
again when we move to point 3’.
inflation—a cost-push inflation.
CAUSES OF INFLATIONARY MONETARY POLICY
High employment targets and inflation
FIGURE 10
LRAS
Inflation Rate, π
Demand-Pull Inflation
AS1
When policymakers mistakenly underestimate the natural rate of unemployment and
so set a target for unemployment that is too low, they set the stage for expansionary
monetary policy that produces inflation.
2’
π1
1
AD2
AD1
Y
P
T
Y
Aggregate Output, Y
If policymakers have set a unemployment target that is below the natural
To hit the unemployment target, policymakers must enact policies such as expansionary
P
rate of unemployment (Y ), they will be trying to achieve an output target
fiscal policy or an autonomous easing of monetary policy to increase aggregate
T
greater than potential output (Y ). Suppose that we are initially at point 1:
demand. The aggregate demand curve shifts to the right until it reaches AD2 and the
T
The economy is at potential output but below the target level of output Y .
T
economy moves to point 2’, where output is at Y and policymakers have achieved the
unemployment rate goal.
CAUSES OF INFLATIONARY MONETARY POLICY
High employment targets and inflation
FIGURE 10
LRAS
Inflation Rate, π
AS4
Demand-Pull Inflation
AS3
T
At Y , the unemployment rate is below the natural rate level, and
output is above potential, causing wages to rise. The short-run
π4
aggregate supply curve will shift up and to the left, eventually to
π3
AS2
4
4’
AS1
3
AS2, moving the economy from point 2’ to point 2, where it is back
at potential output but at a higher inflation rate of π 2.
3’
2
π2
2’
π1
AD4
1
AD3
AD2
AD1
We could stop there, but because unemployment is again higher than
Y
P
T
Y
Aggregate Output, Y
the
target level, policymakers would once more shift the aggregate
demand curve rightward to AD3 to hit the output target at point 3’.
Policymakers fail on two counts: They have not achieved their unemployment
target and have caused higher inflation. If, however, the target rate of
unemployment is below the natural rate, the process we see in Figure 10 will
be well under way before they realize their mistake.
The whole process would continue to drive the economy to point 3
and beyond. The overall result is a steadily rising inflation rate.
CAUSES OF INFLATIONARY MONETARY POLICY
High employment targets and inflation
Cost-Push Versus Demand-Pull Inflation
Cost-Push Inflation
Demand-Pull Inflation
LRAS
LRAS
Inflation Rate, π
AS4
AS4
AS3
π4
AS3
π4
AS2
4
AS2
4
4’
4’
π3
AS1
3
π3
AS1
3
3’
3’
2
π2
π2'
2
π2
2’
2’
π1
AD4
1
π1
AD4
1
AD3
AD3
AD2
AD2
AD1
Y’
Y
P
Aggregate Output, Y
AD1
Y
P
T
Y
Aggregate Output, Y
We would normally expect to see demand-pull inflation when unemployment is below the natural rate level, and cost-push inflation when unemployment is above the natural rate level.
Unfortunately, economists and policymakers still struggle with measuring the natural rate of unemployment. Complicating matters further, a cost-push inflation can be initiated by a demandpull inflation, blurring the distinction. When a demand-pull inflation produces higher inflation rates, expected inflation will eventually rise and cause workers to demand higher wages (costpush inflation) so that their real wages do not fall. Finally, expansionary monetary and fiscal policies produce both kinds of inflation, so we cannot distinguish between them on this basis.