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 inflationFull EmploymentUnstable inflationNominal interest rate = real interest rate + inflationAdds to the risk of lending and borrowingInterferes with long-run financial planningPrefer 2% constant rate to 5 half the time and 1% the other half
5 Two Main Objectives of Monetary Policy – Dual Mandate Full employmentreduce cyclical unemployment to zeroConcerns about cyclical unemploymentIts opportunity costThe output that the unemployed could have produced if they were workingRepresents a social failureCan cause significant hardship
6 The Objectives of Monetary Policy Natural rate of unemploymentunemployment rate when there is no cyclical unemploymentMeasured as sum of frictional and structural unemploymentThe Fed can not affect the natural ratedetermined by supply and demand in the labor market
7 The Objectives of Monetary Policy When unemployment rate < natural rateGDP is greater than potential outputEconomy’s self-correcting mechanism will then create inflation.Look at graphs from chapter 15When unemployment rate > natural rateGDP is below potential outputEconomy’s self-correcting mechanism will then put downward pressure on the price levelGraphs 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 inflationPriceLevelReal GDPLong-Run AS CurveAS2AD2AS1LP4AD1P2NY2P1EYFE
9 The Fed’s Performance - Inflation: 1950 to Present 2%
10 The Fed’s Performance - Unemployment: 1950 to 2011 6%Less success for unemployment compared to inflation
11 Federal Reserve Policy – Theory and Practice Simplifying assumptionslet’s assume the Fed’s goal for the inflation rate is zeroOver the long run, the Fed succeeds in achieving this goalNOTE: in reality Fed’s goal is 2% inflation
12 Federal Reserve Policy – Theory and Practice Three possible Fed responses to demand shocksHold the money supply constant.Maintaining the interest rate i.e., hold it constant.Neutralize (offset) the shockThe 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 targetCall 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 RateMoney(a)Price LevelReal GDP $ Trillions(b)MSASLRASM2dAD2B7%M1dAD1H110A11.55%FE100FE =10.012.5AD 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 RunPrice LevelReal GDP $ TrillionsOutput will overshoot its potential in the short runPrice level will rise in the short run (to 110)Price level will rise further in the long run(to 120)Output returns to FE.ASKAD2120AD1FH11011.5E100FE =10.012.5
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 supplyAn even greater rise in the price level
17 A Positive Demand Shock with a Constant Interest Rate Money(a)Price LevelReal GDP ($ trillions)(b)M1SM2SASM2d150AD3AD1AD2M1dJ13012.5CA5%E110100FE= 10.0AD 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 shockFed’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 targetA positive demand shockRequires an increase in the interest rate targetA negative demand shockRequires a decrease in the interest rate target
19 A Positive Demand Shock Neutralized by Monetary Policy Interest RateMoney(a)Price LevelReal GDP ($ trillions)(b)M2SM1SASM1dAD19%DEA1005%10.0AD2A 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%.
22 A Negative Demand Shock Neutralized by Monetary Policy Interest RateMoney(a)Price LevelReal GDP ($ trillions)(b)M1SASM1dAD1EA1005%10.03%DAD2A 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 pricesManaging 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 stabilityIt will worsen unemploymentInflation ‘hawks”if the Fed tries to maintain high employmentIt will worsen inflationInflation “doves”
25 Policy Dilemma - Responding to Supply Shocks Price LevelReal GDPAS2ADno recessionAD1AS1VP3ADno inflationRP2Y2TP1EY3YFEStarting 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 arises1960s: series of positive demand shocksC 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 ratesWhat 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 timethe public develops expectations that inflation will continueinflation gets built into the economyGreat 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 inflationthe economy continues to generate inflationeven after the self-correcting mechanism has finally been allowed to do its job and bring us back to potential outputWhy?the AS curve will shift upward each yearWorkers expect higher prices and demand higher nominal wagesSuppliers require higher prices
31 Economy at Full Employment with Built-In Inflation PriceLevelReal GDPAS2AD2AD1AS1BP2A’P1AYFEDuring 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 UKNotice 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 perspectiveDuring 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 unemploymentLower rates of inflation will be associated with higher rates of unemploymentThe 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 unemploymentLower rates of inflation will be associated with lower rates of unemploymentThe 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 InflationThe Phillips Curve: A Historical PerspectiveFrom 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’s12%The Phillips Curve shifted up111019741980919791981197581973197871977Inflation Rate1968619711972197619695197019824196619561955198419831965319571954196219672195919581964196111960196312345678910Unemployment Rate in Percent
40 If inflationary expectations increase Inflation Expectations and the Phillips CurveIf inflationary expectations increasethe 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).
42 If inflationary expectations decrease, Inflation Expectations and the Phillips CurveIf 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)
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 Curve YfASU*Verticallong-run aggregatesupplycurveVerticallong-runPhillipscurvePrice LevelInflation RateReal GDPUnemployment Rate(a)(b)
47 PCbuilt-in expected inflation Contractionary Monetary Policy and The Phillips CurveInflationRateUnemployment RateAt 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%E6%UNTo reduce the inflation rate to 3%, the Fed must accept higher unemployment (U1) in the short run.F3%U1
48 Expectations and Ongoing Inflation In the previous slide, the Fedmoves the economy downward and rightward along the Phillips curvethe unemployment rate increasesand inflation rate decreasesA decrease in the inflation rate in the long runlowers built-in inflationary expectationsand 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 DownwardInflationRateUnemploymentPCbuilt-in inflation= 6%E6%PCbuilt-in inflation= 3%UNGF3%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%.InflationRateUnemploymentPCbuilt-in inflation= 9%PCbuilt-in inflation= 6%HJ9%U2E6%UN
51 Expectations and Ongoing Inflation In the Long run there is no tradeoffUnemployment always returns to its natural rateLong-run Phillips curveA vertical lineIn the long run, unemployment must equal its natural rateRegardless of the rate of inflation
52 Long-Run Phillips Curve The Long-Run Phillips CurveThe 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.InflationRateUnemploymentPCbuilt-in inflation= 9%Long-Run Phillips CurvePCbuilt-in inflation= 6%HJ9%PCbuilt-in inflation= 3%U2E6%UNGF3%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 ratesReal interest rate = nominal rate - inflation
55 Challenges for Monetary Policy Information problemsUncertain and varying time lagsPolicies meant to stabilize the economy could instead destabilize itIt 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 problemsUncertainty about natural rate of unemploymentNatural 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 discretionFollowing a rule could help the Fed manage inflationary expectationsMake it easier to take actionsBeneficial in the long runUnpopular in the short runTaylor rule – proposed rule:Require the Fed to change the interest rate by a specified amountWhen 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).