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MONETARY POLICY 32 CHAPTER

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Objectives After studying this chapter, you will be able to Distinguish among the instruments, ultimate goals, and intermediate targets of monetary policy and review the Feds performance Describe and compare the performance of a monetarist fixed rule and Keynesian feedback rules for monetary policy Explain why the outcome of monetary policy crucially depends on the Feds credibility Describe and compare the new monetarist and new Keynesian feedback rules for monetary policy

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What Can Monetary Policy Do? In 2001, real GDP shrank and unemployment increased. Alan Greenspan cut the interest rate to stimulate production and jobs. Were these actions the right ones? Can and should monetary policy try to counter recessions? Or should monetary policy focus on price stability?

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Instruments, Goals, Targets, and the Feds Performance To discuss monetary policy if we distinguish among: Instruments Goals Intermediate targets

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Instruments, Goals, Targets, and the Feds Performance The instruments of monetary policy are Open market operations The discount rate Required reserve ratios The goals of monetary policy are the Feds ultimate objectives and are Price level stability Sustainable real GDP growth close to potential GDP

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Instruments, Goals, Targets, and the Feds Performance The Feds instruments work with an uncertain, long, and variable time lag. To assess its actions, the Fed watches intermediate targets. The possible intermediate targets are Monetary aggregates (M1 and M2, the monetary base) The federal funds rate The Feds intermediate target is the federal funds rate.

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Instruments, Goals, Targets, and the Feds Performance Price Level Stability Unexpected swings in the inflation rate bring costs for borrowers and lenders and employers and workers. What Is Price Level Stability? Alan Greenspan defined price level stability as a condition in which the inflation rate does not feature in peoples economic calculations. An inflation rate between 0 and 3 percent a year is generally seen as being consistent with price level stability.

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Instruments, Goals, Targets, and the Feds Performance Sustainable Real GDP Growth Natural resources and the willingness to save and invest in new capital and new technologies limit sustainable growth. Monetary policy can contribute to potential GDP growth by creating a climate that favors high saving and investment rates. Monetary policy can help to limit fluctuations around potential GDP.

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Instruments, Goals, Targets, and the Feds Performance The Feds Performance: 1973–2003 The Feds performance depends on Shocks to the price level Monetary policy actions

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Instruments, Goals, Targets, and the Feds Performance Shocks to the price level during the 1970s and 1980s made the Feds job harder World oil price hikes Large and increasing budget deficits Productivity slowdown These shocks intensified inflation and slowed real GDP growth.

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Instruments, Goals, Targets, and the Feds Performance Shocks in the 1990s made the Feds job easier. Falling world oil prices Decreasing budget deficits (and eventually a budget surplus) New information economy brought more rapid productivity growth.

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Instruments, Goals, Targets, and the Feds Performance Figure 32.1 summarizes monetary policy 1973-2003.

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Instruments, Goals, Targets, and the Feds Performance There is a tendency for the federal funds rate to fall as an election approaches and usually the incumbent President or his partys successor wins the election. Two exceptions In 1980, interest rates increased, the economy slowed, and Jimmy Carter lost his reelection bid. In 1992, interest rates increased, and George Bush lost his reelection bid.

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Instruments, Goals, Targets, and the Feds Performance Presidents take a keen interest in what the Fed is up to. And as the 2004 election approached, the White House was watching anxiously, hoping that the Fed would continue to favor a low federal funds rate and keep the economy expanding.

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Instruments, Goals, Targets, and the Feds Performance Figure 32.2 provides a neat way of showing how well the Fed has done in shooting at its target.

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Achieving Price Level Stability There are two price level problems When the price level is stable, the problem is to prevent inflation from breaking out. When inflation is already present, the problem is to reduce its rate and restore price level stability while doing the least possible damage to real GDP growth.

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Achieving Price Level Stability The monetary policy regimes that can be used to stabilize aggregate demand are Fixed-rule policies Feedback-rule policies Discretionary policies

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Achieving Price Level Stability Fixed-Rule Policies A fixed-rule policy specifies an action to be pursued independently of the state of the economy. An everyday example of a fixed rule is a stop sign--Stop regardless of the state of the road ahead. A fixed-rule policy proposed by Milton Friedman is to keep the quantity of money growing at a constant rate regardless of the state of the economy.

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Achieving Price Level Stability Feedback-Rule Policies A feedback-rule policy specifies how policy actions respond to changes in the state of the economy. A yield sign is an everyday feedback ruleStop if another vehicle is attempting to use the road ahead, but otherwise, proceed. A monetary policy feedback-rule is one that pushes the interest rate ever higher in response to rising inflation and strong real GDP growth and ever lower in response to falling inflation and recession.

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Achieving Price Level Stability Discretionary Policies A discretionary policy responds to the state of the economy in a possibly unique way that uses all the information available, including perceived lessons from past mistakes. An everyday discretionary policy occurs at an unmarked intersection--each driver uses discretion in deciding whether to stop and how slowly to approach. Most macroeconomic policy actions have an element of discretion because every situation is to some degree unique.

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Achieving Price Level Stability A Monetarist Fixed Rule with Aggregate Demand Shocks If monetary policy follows a monetarist fixed rule in the face of an aggregate demand shock: Aggregate demand fluctuates Real GDP and the price level fluctuate between recession and boom.

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Achieving Price Level Stability Figure 32.3 shows this outcome. On the average, the economy is on aggregate demand curve AD 0 and short-run aggregate supply curve SAS. The price level is 105, and real GDP is $10 trillion.

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Achieving Price Level Stability Aggregate demand fluctuates between AD LOW and AD HIGH. Real GDP and the price level fluctuate between recession and boom.

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Achieving Price Level Stability A Keynesian Feedback Rule with Aggregate Demand Shocks The Keynesian feedback rule raises the interest rate when aggregate demand increases and cuts the interest rate when aggregate demand decreases.

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Achieving Price Level Stability Figure 32.4 illustrates the behavior of the price level and real GDP under this feedback-rule policy if the policy is implemented well.

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Achieving Price Level Stability When aggregate demand decreases to AD LOW, the Fed cuts the interest rate to send aggregate demand back to AD 0. When aggregate demand increases to AD HIGH, the Fed raises the interest rate to send aggregate demand back to AD 0.

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Achieving Price Level Stability The ideal feedback rule will keep aggregate demand close to AD 0 so that the price level remains almost constant and real GDP remains close to potential GDP. A feedback policy might be implemented badly with greater fluctuations in the price level and real GDP than with a fixed rule.

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Achieving Price Level Stability Policy Lags and the Forecast Horizon The effects of policy actions taken today are spread out over the next two years or even more. The Fed cannot forecast that far ahead. The Fed cant predict the precise timing and magnitude of the effects of its policy actions. A feedback policy that reacts to todays economy might be wrong for the economy at that uncertain future date when the policys effects are felt.

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Achieving Price Level Stability Stabilizing Aggregate Supply Shocks Two types of shock occur to bring fluctuations in aggregate supply Productivity growth fluctuations Fluctuations in cost-push pressure

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Achieving Price Level Stability Monetarist Fixed Rule with a Productivity Shock A productivity growth slowdown decreases long-run aggregate supply. With a fixed rule, aggregate demand is unchanged Real GDP decreases and the price level rises.

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Achieving Price Level Stability Figure 32.5 shows this outcome. With no shock, aggregate demand is AD 0 and long- run aggregate supply is LAS 0. The price level is 105 and real GDP is $10 trillion at point A.

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Achieving Price Level Stability A productivity growth slowdown shifts the long- run aggregate supply curve leftward to LAS 1. With a fixed rule, aggregate demand remains at AD 0. Real GDP decreases to $9.5 trillion and the price level rises to 120 at point B.

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Achieving Price Level Stability Feedback Rules with Productivity Shock Real GDP stability conflicts with price stability in the face of a productivity shock. So there are two possible feedback rules Rule to stabilize real GDP Rule to stabilize the price level

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Achieving Price Level Stability Feedback Rule to Stabilize Real GDP Suppose that the Feds feedback rule is: When real GDP decreases, cut the interest rate to increase aggregate demand. This policy brings a rise in the price level but does not prevent the decrease in real GDP. Figure 32.6 shows this outcome.

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Achieving Price Level Stability When real GDP decreases to $9.5 trillion, the Fed cuts the interest rate and increases aggregate demand to AD 1. Real GDP remains at $9.5 trillion and the price level rises to 125 at point C. This case the attempt to stabilize real GDP has no effect on real GDP but destabilizes the price level.

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Achieving Price Level Stability Feedback Rule to Stabilize the Price Level Suppose that the Feds feedback rule is: When the price level rises, raise the interest rate to decrease aggregate demand. In this case, the price level is stable and real GDP is unaffected by the monetary policy Again, Figure 32.6 shows the outcome.

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Achieving Price Level Stability When the price level rises above 105, the Fed increases the interest rate and decreases aggregate demand to AD 2. The price level remains at 105 and real GDP remains at $9.5 trillion at point D.

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Achieving Price Level Stability When a productivity shock occurs, a feedback rule that targets the price level delivers a more stable price level and has no adverse effects on real GDP.

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Achieving Price Level Stability Monetarist Fixed Rule with a Cost-Push Inflation Shock If the Fed follows a monetarist fixed rule, it holds aggregate demand constant when a cost-push inflation shock occurs. Real GDP decreases and the price level rises stagflation.

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Achieving Price Level Stability Figure 32.7(a) shows this outcome. The economy starts out at full employment at point A. A cost-push inflation shock shifts the SAS curve leftward from SAS 0 to SAS 1.

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Achieving Price Level Stability The Fed takes no policy action and the aggregate demand curve remains at AD 0. The price level rises to 115, and real GDP decreases to $9.5 trillion at point B. The economy has experienced stagflation.

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Achieving Price Level Stability There is a recessionary gap that eventually lowers the money wage rate and returns the economy to full employment. But this adjustment takes a long time.

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Achieving Price Level Stability Feedback Rules with Cost-Push Inflation Shock Again, there are two feedback rules Rule to stabilize real GDP Rule to stabilize the price level

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Achieving Price Level Stability Feedback rule to stabilize real GDP When a cost-push inflation shock occurs, the Fed cuts the interest rate and increases aggregate demand. The price level rises and real GDP returns to potential GDP. If the Fed keeps responding to repeated cost-push shocks in this way, a cost-push inflation takes hold. Figure 32.7(b) shows this outcome.

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Achieving Price Level Stability When a cost-push inflation shock sends the economy to point B, the Fed cuts the interest rate and increases aggregate demand to AD 1. The price level rises to 120, and real GDP returns to $10 trillion at point C. The economy has experienced cost-push inflation that could become an ongoing inflation.

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Achieving Price Level Stability Feedback Rule to Stabilize the Price Level A cost-push inflation shock leads the Fed to raise the interest rate and decreases aggregate demand. The Fed avoids cost-push inflation but at the cost of deep recession. Figure 32.7(c) shows this outcome.

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Achieving Price Level Stability A cost-push inflation shock sends the economy to point B The Fed raises the interest rate and decreases aggregate demand to AD 2. The price level falls to 105, and real GDP decreases to $8.5 trillion at point D. The Fed has avoided cost- push inflation but at the cost of recession.

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Policy Credibility A policy that is credible works much better than one that surprises. Contrast two cases A surprise inflation reduction A credible announced inflation reduction

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Policy Credibility A Surprise Inflation Reduction Figure 32.8(a) shows the economy at full employment on aggregate demand curve AD 0 and short-run aggregate supply curve SAS 0. Real GDP is $10 trillion, and the price level is 105.

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Policy Credibility The expected inflation rate is 10 percent. So next year, aggregate demand is expected to be AD 1 and the money wage rate increases to shift the short-run aggregate supply curve SAS 1.

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Policy Credibility If expectations are fulfilled, the price level rises to 115.5a 10 percent inflationand real GDP remains at potential GDP. Now suppose that the Fed unexpectedly decides to slow inflation.

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Policy Credibility The Fed raises the interest rate and slows aggregate demand growth. The aggregate demand curve shifts rightward to AD 2. Real GDP decreases to $9.5 trillion, and the price level rises to 113.4an inflation rate of 8 percent a year.

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Policy Credibility Figure 32.8(b) shows the same events using the Phillips curve. The economy at full employment on long run Phillips curve, LRPC, and short-run Phillips curve, SRPC 0. Inflation is 10 percent and unemployment 6 percent.

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Policy Credibility When the Fed increases the interest rate, the economy moves along the short-run Phillips curve SRPC 0 as unemployment rises to 9 percent and inflation falls to 8 percent a year.

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Policy Credibility The Feds policy has succeeded in slowing inflation, but at the cost of recession. Real GDP is below potential GDP, and unemployment is above its natural rate.

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Policy Credibility A Credible Announced Inflation Reduction Suppose the Fed announces its intention to slow inflation to 5 percent. Suppose also that the Feds policy announcement is credible and convincing. The expected inflation rate becomes 5 percent a year.

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Policy Credibility In Figure 32.8(a), the SAS curve shifts to SAS 2. Aggregate demand increases by the amount expected, and the aggregate demand curve shifts to AD 2. The price level rises to 110.25inflation is 5 percentand real GDP remains at potential GDP.

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Policy Credibility In Figure 32.8(b), the lower expected inflation rate shifts the short-run Phillips curve downward to SRPC 1, and inflation falls to 5 percent a year, while unemployment remains at its natural rate of 6 percent.

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Policy Credibility A credible announced inflation reduction lowers inflation but with no accompanying recession or increase in unemployment.

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Policy Credibility Inflation Reduction in Practice When the Fed in fact slowed inflation in 1981, we paid a high price. The Feds policy action to end inflation was not credible. Could the Fed have lowered inflation without causing recession by telling people far enough ahead of time that it did indeed plan to lower inflation? The answer appears to be no. People expect the Fed to behave in line with its record, not with its stated intentions.

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New Monetarist and New Keynesian Feedback Rules A monetarist rule Prevents cost-push inflation at the cost of recession Brings price level fluctuations in the face of productivity shocks Brings price level and real GDP fluctuations in the face of aggregate demand fluctuations

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New Monetarist and New Keynesian Feedback Rules A Keynesian feedback rule that targets real GDP Brings cost-push inflation Might not moderate fluctuations in the price level and real GDP that stem from aggregate demand shocks A Keynesian feedback rule that targets the price level Prevents cost-push inflation but at an even greater cost of recession than that of a monetarist fixed rule.

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New Monetarist and New Keynesian Feedback Rules None of these rules work well, and none is a sufficiently credible rule for the Fed to commit to. In an attempt to develop a rule that is credible and that works well, economists have explored policies that respond to both the price level and real GDP. Two such policy rules are the McCallum Rule Taylor Rule

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New Monetarist and New Keynesian Feedback Rules The McCallum Rule Suggested by Bennett T. McCallum, an economics professor at Carnegie-Mellon University, the McCallum rule says Make the monetary base grow at a rate equal to the target inflation rate plus the 10-year moving average growth rate of real GDP minus the 4-year moving average of the growth rate of the velocity of circulation of the monetary base.

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New Monetarist and New Keynesian Feedback Rules If the Fed had a specific target for the inflation rate, the McCallum rule would tell the Fed the growth rate of monetary base that would achieve that target, on the average. Figure 32.9 on the next slide shows how the monetary base has grown and how it would have grown if it had followed the McCallum rule.

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New Monetarist and New Keynesian Feedback Rules

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The Taylor Rule Suggested by John Taylor, formerly an economics professor at Stanford University and now Undersecretary of the Treasury for International Affairs in the Bush administration, the Taylor rule says Set the federal funds rate equal to the target inflation rate plus 2.5 percent plus one half of the gap between the actual inflation rate and the target inflation rate plus one half of the percentage deviation of real GDP from potential GDP.

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New Monetarist and New Keynesian Feedback Rules Figure 32.10 shows the federal funds rate and the rate if the Taylor rule were followed.

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New Monetarist and New Keynesian Feedback Rules Differences Between the Rules The McCallum rule and the Taylor rule tell a similar story about the inflation of the 1970s and the price level stability of the 1990s and 2000s. During the 1970s, the quantity of money grew too rapidly (McCallum rule) and the federal funds rate was too low (Taylor rule).

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New Monetarist and New Keynesian Feedback Rules Differences Between the Rules During the 1990s and 2000s, both the growth rate of the quantity of money (McCallum rule) and the federal funds rate (Taylor rule) were consistent with low inflation and price level stability. But the two rules differ in two important ways Strength of response to output fluctuations Targeting money versus the interest rate

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New Monetarist and New Keynesian Feedback Rules Choosing Between the Rules Monetarists favor targeting the monetary base because they believe that it provides a more solid anchor for the price level than does the interest rate. Keynesians say that targeting the quantity of money would bring excessive swings in the interest rate, which in turn would bring excessive swings in aggregate expenditure. For this reason, Keynesians favor interest rate targeting.

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THE END

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