1. Inflation and Monetary Policy Chapter 16

2. Inflation and Monetary Policy
In 1970s inflation was as high as 13 percent - public was very concerned about inflation.
1991 to 2008, inflation was around 2.5 percent.
2009 to 2011, recession, deflation a major concern

3. Inflation and Monetary Policy
Why was inflation high?
How was it reduced?
Why is deflation a concern?

4. Two Main Objectives of Monetary Policy – The Federal Reserve’s Dual Mandate
Low, stable inflation
Full Employment
Unstable inflation
Nominal interest rate = real interest rate + inflation
Adds to the risk of lending and borrowing
Interferes with long-run financial planning
Prefer 2% constant rate to 5 half the time and 1% the other half

5. Two Main Objectives of Monetary Policy – Dual Mandate
Full employment
reduce cyclical unemployment to zero
Concerns about cyclical unemployment
Its opportunity cost
The output that the unemployed could have produced if they were working
Represents a social failure
Can cause significant hardship

6. The Objectives of Monetary Policy
Natural rate of unemployment
unemployment rate when there is no cyclical unemployment
Measured as sum of frictional and structural unemployment
The Fed can not affect the natural rate
determined by supply and demand in the labor market

7. The Objectives of Monetary Policy
When unemployment rate < natural rate
GDP is greater than potential output
Economy’s self-correcting mechanism will then create inflation.
Look at graphs from chapter 15
When unemployment rate > natural rate
GDP is below potential output
Economy’s self-correcting mechanism will then put downward pressure on the price level
Graphs from chapter 15

8. Unemployment Rate < Natural Rate
After the positive demand shock and all the long-run adjustments to it, the economy ends up at point L with a higher price level (P4), but the same full-employment output level (YFE).
Economy’s self-correcting mechanism will then create inflation
Price
Level
Real GDP
Long-Run AS Curve
AS2
AD2
AS1 L P4
AD1 P2 N Y2 P1 E
YFE

9. The Fed’s Performance - Inflation: 1950 to Present2%

10. The Fed’s Performance - Unemployment: 1950 to 20116%
Less success for unemployment compared to inflation

11. Federal Reserve Policy – Theory and Practice
Simplifying assumptions
let’s assume the Fed’s goal for the inflation rate is zero
Over the long run, the Fed succeeds in achieving this goal
NOTE: in reality Fed’s goal is 2% inflation

12. Federal Reserve Policy – Theory and Practice
Three possible Fed responses to demand shocks
Hold the money supply constant.
Maintaining the interest rate i.e., hold it constant.
Neutralize (offset) the shock
The first 2 responses are poor policies!

13. Federal Reserve Policy -Theory and Practice
Case 1 - Fully employed economy experiences a positive demand shock and Fed’s policy is constant money supply target
Call this the“do nothing” policy.
Wait and let the economy self-correct

14. A Positive Demand Shock with a Constant Money Supply - Short-run
Interest Rate
Money
(a)
Price Level
Real GDP $ Trillions
(b) MS AS
LRAS
M2d
AD2 B 7%
M1d
AD1 H
110 A
11.5 5% F E
100
FE =10.0
12.5
AD curve shifts rightward to AD2 , causing both the price level and output to rise. If the Fed maintains a constant money supply, the rise in the price level causes the money demand curve to shift to M2d in panel (a), driving the interest rate up from 5 percent to 7%. A higher interest rate causes some crowding out of consumption and investment spending, but not complete crowding out. In panel (b), output increases the price level rises as well (point H).

15. Output will overshoot its potential in the short run
A Positive Demand Shock with a Constant Money Supply -
Long Run
Price Level
Real GDP $ Trillions
Output will overshoot its potential in the short run
Price level will rise in the short run (to 110)
Price level will rise further in the long run
(to 120)
Output returns to FE. AS K
AD2
120
AD1 F H
110
11.5 E
100
FE =10.0
12.5

16. Federal Reserve Policy -Theory and Practice
Case 2 - Fully employed economy experiences a positive demand shock and Fed’s policy is constant interest rate.
In this case, things are worse:
An even greater overshooting of potential output than a constant money supply
An even greater rise in the price level

17. A Positive Demand Shock with a Constant Interest Rate
Money
(a)
Price Level
Real GDP ($ trillions)
(b)
M1S
M2S AS
M2d
150
AD3
AD1
AD2
M1d J
130
12.5 C A 5% E
110
100
FE= 10.0
AD curve shifts rightward to AD2 causing both price level and output to rise. The rise in the price level shifts the money demand curve rightward to M2d in panel (a), which would ordinarily cause the interest rate to rise. But if the Fed holds a constant interest rate target, it will increase the money supply to prevent any rise in the interest rate. There will be no crowding out of consumption or investment, so the AD curve in panel (b) shifts farther rightward (to AD3 ). As a result, the economy ends up at point J, with output and the price level rising by more than under a constant-money-supply policy.

18. Federal Reserve Policy -Theory and Practice
Fully employed economy experiences a demand shock
Fed’s best policy is to offset the demand shock – neutralize it.
To prevent any shift in AD at all the Fed must change its interest rate target
A positive demand shock
Requires an increase in the interest rate target
A negative demand shock
Requires a decrease in the interest rate target

19. A Positive Demand Shock Neutralized by Monetary Policy
Interest Rate
Money
(a)
Price Level
Real GDP ($ trillions)
(b)
M2S
M1S AS
M1d
AD1 9% D E A
100 5%
10.0
AD2
A positive demand shock begins to shift the AD curve rightward in panel (b), which would ordinarily cause both the price level and output to rise. But the Fed can neutralize the shock by increasing its interest rate target enough to cause complete crowding out of consumption and investment spending. The Fed must decrease the money supply in panel (a), moving the money market equilibrium to a point like D. This reverses (or prevents) the shift in the AD curve, so the economy ends up at point E in panel (b), at its initial output and price level.

20. Federal Reserve Policy
From June 2004 to June 2006 the Fed felt the economy was growing too rapidly (AD shifting to the right too rapidly)
The Fed increased its federal fund rate target 17 times in 2 years from 1% to 5.25%.

21. Federal Funds Target Rate

22. A Negative Demand Shock Neutralized by Monetary Policy
Interest Rate
Money
(a)
Price Level
Real GDP ($ trillions)
(b)
M1S AS
M1d
AD1 E A
100 5%
10.0 3% D
AD2
A negative demand shock begins to shift the AD curve leftward in panel (b), which would ordinarily cause both the price level and output to fall. But the Fed can neutralize the shock by decreasing its interest rate target enough to cause complete crowding in of consumption and investment spending. The Fed must increase the money supply in panel (a), moving the money market equilibrium to a point like D. This reverses (or prevents) the shift in the AD curve, so the economy ends up at point E in panel (b), at its initial output and price level.

23. Federal Reserve Policy
Beginning in September 2007 the Fed decreased its federal funds rate target 10 times from 5.25% to 0.25% in 15 months trying to offset the negative demand shock resulting from the fall in housing prices
Managing AD by changing the federal funds rate is not an easy task. Easier said than done!

24. Federal Reserve Policy Dilemma
Responding to supply shocks:
if the Fed tries to preserve price stability
It will worsen unemployment
Inflation ‘hawks”
if the Fed tries to maintain high employment
It will worsen inflation
Inflation “doves”

25. Policy Dilemma - Responding to Supply Shocks
Price Level
Real GDP
AS2
ADno recession
AD1
AS1 V P3
ADno inflation R P2 Y2 T P1 E Y3
YFE
Starting at point E, a negative supply shock shifts the AS curve to AS2. With a constant money supply, new short-run equilibrium would be established at point R, with a higher price level (P2) and lower level of output(Y2). The Fed could prevent inflation by decreasing the money supply and shifting AD to ADno inflation, but output would fall to Y3. At the other extreme, it could increase the money supply and shift the AD curve to ADno recession. This would keep output at the full-employment level, but at the cost of a higher price level, P3.

26. Federal Reserve Policy
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 (dove policy)
It can limit inflation, but only at the cost of a deeper recession (hawk policy)
What about the economy’s self-correcting mechanism?

27. Central Bank Policy US - Dual mandate
European Central Bank and the Bank of England - Price stability is the primary mandate.

28. Inflation Expectations and Ongoing Inflation
How ongoing inflation arises
1960s: series of positive demand shocks
C and I increasing. G increasing (Vietnam and Johnson’s War on Poverty)
unemployment very low, close to 3%
Fed policy was to maintain low interest rates
What effect does this have on AD?
What effect would the economy’s self-correcting mechanism have had?
Dr. Neri will draw a pretty graph now.

29. Inflation Expectations and Ongoing Inflation
When inflation continues for some time
the public develops expectations that inflation will continue
inflation gets built into the economy
Great quote : “We have inflation because we expect it, we expect inflation because we have it”.

30. Inflation Expectations and Ongoing Inflation
Once there is built-in inflation
the economy continues to generate inflation
even after the self-correcting mechanism has finally been allowed to do its job and bring us back to potential output
Why?
the AS curve will shift upward each year
Workers expect higher prices and demand higher nominal wages
Suppliers require higher prices

31. Economy at Full Employment with Built-In Inflation
Price
Level
Real GDP
AS2
AD2
AD1
AS1 B P2 A’ P1 A
YFE
During the year, the aggregate supply curve shifts upward by the built-in rate of inflation. To keep the economy at full employment, the Fed shifts the AD curve rightward by increasing the money supply. The economy goes to point B.
Does the process stop here?

32. Ongoing Inflation and the Phillips Curve
A curve indicating the Fed’s choices between inflation and unemployment in the short run

33. The “Original” Phillips Curve
Developed in 1958 by A.W. Phillips.
Plotted the relationship he observed in data between the % change in money wages and the unemployment rate.
Used the years:
Used data from the UK
Notice that the percentage change in the price level is on the vertical axis, not the price level (P) itself.
The theory behind the Phillips Curve is somewhat different to the theory behind the AS curve, although the insights gained from the AS/AD analysis regarding the behavior of the price level also apply to the behavior of the inflation rate.

34. The “Modern” Phillips Curve
Plots the inflation rate against the unemployment rate.
Recall: the inflation rate is the percentage change in the price level.
The Phillips Curve plots the inflation rate on the vertical axis and the unemployment rate on the horizontal axis.

35. The Short-Run Relationship Between the Unemployment Rate and Inflation
Historical perspective
During the 1960s, there seemed to be an obvious trade-off between inflation and unemployment. Policy debates during the period revolved around this apparent trade-off.

36. Demand-Side (Demand Pull) Inflation and the Phillips Curve
If the change in real GDP is primarily caused by a change in AD:
Higher rates of inflation will be associated with lower rates of unemployment
Lower rates of inflation will be associated with higher rates of unemployment
The U.S. data for the 1960’s on the previous slide shows such a relationship.

37. Supply-Side (Cost Push) Inflation and the Collapse of Phillips Curve
If  GDP is primarily caused by AS:
Higher rates of inflation will be associated with higher rates of unemployment
Lower rates of inflation will be associated with lower rates of unemployment
The U.S. data for and show such a relationship.

38. The Phillips Curve: A Historical Perspective
The Short-Run Relationship between the Unemployment Rate and Inflation
The Phillips Curve: A Historical Perspective
From the 1970s on, it became clear that the relationship between unemployment and inflation was anything but simple.

39. Unemployment Rate in Percent
The Phillips Curve: A Historical Perspective 1950’s, 1960’s and 1970’s and early 1980’s
12%
The Phillips Curve shifted up 11 10
1974
1980 9
1979
1981
1975 8
1973
1978 7
1977
Inflation Rate
1968 6
1971
1972
1976
1969 5
1970
1982 4
1966
1956
1955
1984
1983
1965 3
1957
1954
1962
1967 2
1959
1958
1964
1961 1
1960
1963 1 2 3 4 5 6 7 8 9 10
Unemployment Rate in Percent

40. If inflationary expectations increase
Inflation Expectations and the Phillips Curve
If inflationary expectations increase
the result will be an increase in the rate of inflation even though the unemployment rate may not have changed.
There will be more inflation at any given level of the unemployment rate.
In this case, the Phillips Curve will shift up (to the right).

41. The Phillips Curve Shifts Upward
Inflation
Rate
Unemployment
PCbuilt-in expected inflation
= 9%
PCbuilt-in expected inflation
= 6% J 9% E 6% UN

42. If inflationary expectations decrease,
Inflation Expectations and the Phillips Curve
If inflationary expectations decrease,
the result will be a decrease in the rate of inflation even though the unemployment rate may not have changed.
There will be less inflation at any given level of the unemployment rate.
The Phillips Curve will shift down (to the left)

43. The Phillips Curve Shifts Downward
Inflation
Rate
Unemployment
PCbuilt-in expected inflation
= 6% E 6%
PCbuilt-in expected inflation
= 3% UN G 3%

44. The Phelps/Friedman “Take”
Two famous economists:
Edmund Phelps (1967)
Milton Friedman (1968)
Downward sloping Phillips Curve is only a SR concept.
In the LR the Phillips Curve is vertical at Un, the natural rate of unemployment.
Expectations play a key role.

45. Expectations are self-fulfilling:
Wage inflation is affected by expectations of future price inflation, since workers care about real wages!
Price expectations that affect wage contracts eventually affect prices themselves.
Inflationary expectations shift the SR Phillips Curve to the right.
Note: Inflationary expectations were stable in the 1950s and 1960s, but increased in the 1970s and into the 1980s.

46. Vertical AS Curve and the Vertical Phillips CurveYf AS U*
Vertical
long-run aggregate
supply
curve
Vertical
long-run
Phillips
curve
Price Level
Inflation Rate
Real GDP
Unemployment Rate
(a)
(b)

47. PCbuilt-in expected inflation
Contractionary Monetary Policy and The Phillips Curve
Inflation
Rate
Unemployment Rate
At E, the economy is in long-run equilibrium: unemployment at its natural rate (UN) and inflation at the built-in rate (6%).
PCbuilt-in expected inflation
= 6% E 6% UN
To reduce the inflation rate to 3%, the Fed must accept higher unemployment (U1) in the short run. F 3% U1

48. Expectations and Ongoing Inflation
In the previous slide, the Fed
moves the economy downward and rightward along the Phillips curve
the unemployment rate increases
and inflation rate decreases
A decrease in the inflation rate in the long run
lowers built-in inflationary expectations
and the Phillips curve shifts downward

49. The Phillips Curve Shifts Downward
Initially, the economy is at point E, with inflation equal to the built-in rate of 6%. If the Fed moves the economy to point F and keeps it there for some time, the public will eventually come to expect 3% inflation in the future. The built-in inflation rate will fall and the Phillips curve will shift downward to PCbuilt-in inflation = 3%. The economy will move to point G in the long run, with unemployment at the natural rate and an actual inflation rate equal to the built-in rate of 3%
The Phillips Curve Shifts Downward
Inflation
Rate
Unemployment
PCbuilt-in inflation
= 6% E 6%
PCbuilt-in inflation
= 3% UN G F 3% U1

50. Expansionary Monetary Policy - The Phillips Curve Shifts Upward
Initially, the economy is at point E, with inflation equal to the built-in rate of 6%. If the Fed moves the economy to point H and keeps it there for some time, the public will eventually come to expect 9% inflation in the future. The built-in inflation rate will rise and the Phillips curve will shift upward to PCbuilt-in inflation = 9%. The economy will move to point J in the long run, with unemployment at the natural rate and an actual inflation rate equal to the built-in rate of 9%.
Inflation
Rate
Unemployment
PCbuilt-in inflation
= 9%
PCbuilt-in inflation
= 6% H J 9% U2 E 6% UN

51. Expectations and Ongoing Inflation
In the Long run there is no tradeoff
Unemployment always returns to its natural rate
Long-run Phillips curve
A vertical line
In the long run, unemployment must equal its natural rate
Regardless of the rate of inflation

52. Long-Run Phillips Curve
The Long-Run Phillips Curve
The vertical line is the economy’s long-run Phillips curve, showing all combinations of unemployment and inflation the Fed can choose in the long run. The curve is vertical because in the long run, the unemployment rate must equal the natural rate. Starting at point E with 6% inflation, the Fed can choose unemployment at the natural rate with either a higher rate of inflation (point J ) or a lower rate of inflation (point G ). But points off of the vertical line are not sustainable in the long run.
Inflation
Rate
Unemployment
PCbuilt-in inflation
= 9%
Long-Run Phillips Curve
PCbuilt-in inflation
= 6% H J 9%
PCbuilt-in inflation
= 3% U2 E 6% UN G F 3% U1

53. Why does the Fed Allow Ongoing Inflation?
The Fed has tolerated measured inflation at about 2 percent per year because:
It knows that the true rate of inflation is lower (measurement problem)
Ongoing inflation may help labor markets adjust more easily.
Suppose excess supply of labor and real wage needs to fall 3% in an industry – can happen 2 ways – nominal wage falls or prices increase. P ↑ = (W/P) ↓

54. Why does the Fed Allow Ongoing Inflation?
The Fed has tolerated measured inflation at 2 percent per year because:
Ongoing inflation gives the Fed more flexibility to bring down real interest rates
Real interest rate = nominal rate - inflation

55. Challenges for Monetary Policy
Information problems
Uncertain and varying time lags
Policies meant to stabilize the economy could instead destabilize it
It takes up to 1 years for a change in the money supply to affect real GDP.
It takes about 1 year for a change in real GDP to affect the rate of inflation

56. Challenges for Monetary Policy
Information problems
Uncertainty about natural rate of unemployment
Natural rate is an estimate.
If the Fed believes the natural rate of unemployment is 4.5% but its actually 5%, the Fed will overheat the economy and raise the inflation rate.

57. Challenges for Monetary Policy
Rules versus discretion
Following a rule could help the Fed manage inflationary expectations
Make it easier to take actions
Beneficial in the long run
Unpopular in the short run
Taylor rule – proposed rule:
Require the Fed to change the interest rate by a specified amount
When real GDP or inflation deviates from target

58. THE COST OF REDUCING INFLATION
To reduce inflation, an economy must endure a period of high unemployment and low output.
When the Fed combats inflation, the economy moves down the short-run Phillips curve.
The economy experiences lower inflation but at the cost of higher unemployment.

59. Expectations and Ongoing Inflation
Would the Fed ever create a recession to kill inflation expectations?
YES! Paul Volcker 1979 – 1982.

60. The Volcker Disinflation
When Paul Volcker became Fed chairman in 1979, inflation was widely viewed as one of the nation’s foremost problems.
Volcker succeeded in reducing inflation (from 10 percent to 4 percent), but at the cost of high employment (about 10 percent in 1983).

61. The Volcker Disinflation
Inflation Rate
(percent per year) 10
1980
1981
1979 A 8
1982 6
1984
1983 B 4
1987 C
1985
1986 2 1 2 3 4 5 6 7 8 9 10
Unemployment
Rate (percent)
Copyright © South-Western

62. The Volcker Disinflation
Inflation Rate
(percent per year) 10
1980
1981
1979 A 8
1982 6
1984
1983 B 4
1987 C
1985
1986 2 1 2 3 4 5 6 7 8 9 10
Unemployment
Rate (percent)
Copyright © South-Western