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Inflation and Monetary Policy Chapter 16 CHAPTER 1.

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Presentation on theme: "Inflation and Monetary Policy Chapter 16 CHAPTER 1."— Presentation transcript:

1 Inflation and Monetary Policy Chapter 16 CHAPTER 1

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

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

4 Two Main Objectives of Monetary Policy – The Federal Reserve’s Dual Mandate 1.Low, stable inflation 2.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 4

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 5

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 6

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 7

8 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 (P 4 ), but the same full- employment output level (Y FE ). Economy’s self- correcting mechanism will then create inflation Unemployment Rate < Natural Rate 8 Price Level Real GDP AS 1 Y FE P1P1 AD 1 E AD 2 Y2Y2 P2P2 N AS 2 L P4P4 Long-Run AS Curve

9 The Fed’s Performance - Inflation: 1950 to Present 9 2%

10 The Fed’s Performance - Unemployment: 1950 to Less success for unemployment compared to inflation 6%

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 11

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! 12

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 13

14 AD curve shifts rightward to AD 2, 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 M 2 d 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). A Positive Demand Shock with a Constant Money Supply - Short-run 14 Price Level Real GDP $ Trillions (b) Interest Rate Money (a) M1dM1d 7% MSMS 5% A M2dM2d B AS 110 FE = AD 1 E AD 2 H F LRAS

15 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. A Positive Demand Shock with a Constant Money Supply - Long Run 15 Price Level Real GDP $ Trillions AS 110 FE = AD 1 E AD 2 H F 120 K

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 16

17 AD curve shifts rightward to AD 2 causing both price level and output to rise. The rise in the price level shifts the money demand curve rightward to M 2 d 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 AD 3 ). 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. A Positive Demand Shock with a Constant Interest Rate 17 Price Level Real GDP ($ trillions) (b) Interest Rate Money (a) M1dM1d M1SM1S 5% A M2dM2d AS 130 FE= AD 1 E AD 2 AD 3 M2SM2S C J

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 18

19 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. A Positive Demand Shock Neutralized by Monetary Policy 19 Price Level Real GDP ($ trillions) (b) Interest Rate Money (a) M1dM1d 9% M1SM1S 5% A AS AD 1 E M2SM2S D AD 2

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%. 20

21 21 Federal Funds Target Rate

22 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. A Negative Demand Shock Neutralized by Monetary Policy 22 Price Level Real GDP ($ trillions) (b) Interest Rate Money (a) M1dM1d 3% M1SM1S 5% A AS AD 1 E D AD 2

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! 23

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” 24

25 Starting at point E, a negative supply shock shifts the AS curve to AS 2. With a constant money supply, new short-run equilibrium would be established at point R, with a higher price level (P 2 ) and lower level of output(Y 2 ). The Fed could prevent inflation by decreasing the money supply and shifting AD to AD no inflation, but output would fall to Y 3. At the other extreme, it could increase the money supply and shift the AD curve to AD no recession. This would keep output at the full-employment level, but at the cost of a higher price level, P 3. Policy Dilemma - Responding to Supply Shocks 25 Price Level Real GDP AS 2 Y FE P1P1 AD 1 Y2Y2 P2P2 R AS 1 P3P3 E AD no recession AD no inflation Y3Y3 T V

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? 26

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

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. 28

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”. 29

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 30

31 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? Economy at Full Employment with Built-In Inflation 31 Price Level Real GDP AS 2 Y FE P1P1 AD 1 AS 1 P2P2 A AD 2 B A’A’

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

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

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

39 % Inflation Rate 1 Unemployment Rate in Percent The Phillips Curve: A Historical Perspective 1950’s, 1960’s and 1970’s and early 1980’s The Phillips Curve shifted up

40 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). Inflation Expectations and the Phillips Curve

41 The Phillips Curve Shifts Upward 41 Inflation Rate Unemployment Rate 6% PC built-in expected inflation = 6% 9% E UNUN PC built-in expected inflation = 9% J

42 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) Inflation Expectations and the Phillips Curve

43 The Phillips Curve Shifts Downward 43 Inflation Rate Unemployment Rate 3% PC built-in expected inflation = 6% 6% E UNUN PC built-in expected inflation = 3% G

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 Vertical long-run Phillips curve Inflation Rate (b) Unemployment Rate Vertical long-run aggregate supply curve Price Level (a) Real GDP U* Yf AS

47 Contractionary Monetary Policy and The Phillips Curve 47 Inflation Rate Unemployment Rate U1U1 3% PC built-in expected inflation = 6% 6% F E UNUN At E, the economy is in long-run equilibrium: unemployment at its natural rate (U N ) and inflation at the built-in rate (6%). To reduce the inflation rate to 3%, the Fed must accept higher unemployment (U 1 ) in the short run.

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 48

49 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 PC built-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 49 Inflation Rate Unemployment Rate U1U1 3% PC built-in inflation = 6% 6% F E UNUN PC built-in inflation = 3% G

50 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 PC built-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%. Expansionary Monetary Policy - The Phillips Curve Shifts Upward 50 Inflation Rate Unemployment Rate U2U2 6% PC built-in inflation = 6% 9% H E UNUN PC built-in inflation = 9% J

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 51

52 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. The Long-Run Phillips Curve 52 Inflation Rate Unemployment Rate U1U1 3% PC built-in inflation = 6% 6% E UNUN PC built-in inflation = 3% G PC built-in inflation = 9% U2U2 9% F H J Long-Run Phillips Curve

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) ↓ 53

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 54

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 55

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. 56

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 57

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 –

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 Unemployment Rate (percent) Inflation Rate (percent per year) A 1983 B 1987 C Copyright © 2004 South-Western

62 The Volcker Disinflation Unemployment Rate (percent) Inflation Rate (percent per year) A 1983 B 1987 C Copyright © 2004 South-Western


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