© 2001 South-Western, a division of Thomson Learning Economics: Principles and Applications, 2e by Robert E. Hall & Marc Lieberman © 2001 South-Western, a division of Thomson Learning

Inflation and Monetary Policy © 2001 South-Western, a division of Thomson Learning

The Objectives of Monetary Policy Low, Stable Inflation Full Employment © 2001 South-Western, a division of Thomson Learning

The Objectives of Monetary Policy In addition to keeping the inflation rate low, the Fed tries to keep it stable from year to year. The Fed, as a public agency, chooses its policies with the costs of inflation in mind. © 2001 South-Western, a division of Thomson Learning

The Objectives of Monetary Policy Natural Rate of Unemployment The unemployment rate when there is no cyclical unemployment. © 2001 South-Western, a division of Thomson Learning

The Objectives of Monetary Policy When the unemployment rate is below the natural rate, GDP is greater than potential output. The economy’s self-correcting mechanism will then create inflation. © 2001 South-Western, a division of Thomson Learning

The Objectives of Monetary Policy When the unemployment rate is above the natural rate, GDP is below potential output. The self-correcting mechanism will then put downward pressure on the price level. © 2001 South-Western, a division of Thomson Learning

© 2001 South-Western, a division of Thomson Learning The Fed’s Performance The Fed has had a good--and improving--record in recent years. The inflation rate has been kept low and relatively stable, and--especially in the last few years--unemployment has been near most estimates of the natural rate. © 2001 South-Western, a division of Thomson Learning

Federal Reserve Policy: Theory and Practice Responding to Changes in Money Demand Responding to Spending Shocks Responding to Supply Shocks © 2001 South-Western, a division of Thomson Learning

Federal Reserve Policy: Theory and Practice Passive Monetary Policy When the Fed keeps the money supply constant regardless of shocks to the economy. © 2001 South-Western, a division of Thomson Learning

Federal Reserve Policy: Theory and Practice Active Monetary Policy When the Fed changes the money supply to achieve some objective. © 2001 South-Western, a division of Thomson Learning

Federal Reserve Policy: Theory and Practice Interest Rate Target The interest rate the Federal Reserve aims to achieve by adjusting the money supply. © 2001 South-Western, a division of Thomson Learning

Federal Reserve Policy: Theory and Practice To deal with money demand shocks, the Fed sets an interest rate target and changes the money supply as needed to maintain the target. In this way, the Fed can achieve its goals of price stability and full employment simultaneously. © 2001 South-Western, a division of Thomson Learning

Federal Reserve Policy: Theory and Practice To maintain full employment and price stability after a spending shock, the Fed must change its interest rate target. A positive spending shock requires an increase in the target; a negative spending shock requires a decrease in the target. © 2001 South-Western, a division of Thomson Learning

Federal Reserve Policy: Theory and Practice The stock and bond markets move in the opposite direction to the Fed’s interest rate target: When the Fed raises its target, stock and bond prices fall; when it lowers its target, stock and bond prices rise. © 2001 South-Western, a division of Thomson Learning

Federal Reserve Policy: Theory and Practice Good news about the economy sometimes leads to expectations that the Fed--fearing inflation--will raise its interest rate target. This is why good economic news sometimes causes stock and bond prices to fall. © 2001 South-Western, a division of Thomson Learning

Federal Reserve Policy: Theory and Practice Bad news about the economy sometimes leads to expectations that the Fed--fearing recession--will lower its interest rate target. This is why bad economic news sometimes causes stock and bond prices to rise. © 2001 South-Western, a division of Thomson Learning

Federal Reserve Policy: Theory and Practice An adverse supply shock presents the Fed with a short-run trade-off: It can limit the recession, but only at the cost of more inflation; and it can limit inflation, but only at the cost of a deeper recession. © 2001 South-Western, a division of Thomson Learning

Federal Reserve Policy: Theory and Practice The Fed should choose a hawkish policy if it cares more about price stability, and a dovish policy if it cares more about the stability of output and employment. © 2001 South-Western, a division of Thomson Learning

Expectations and Ongoing Inflation How Ongoing Inflation Arises Ongoing Inflation and the Phillips Curve Why the Fed Allows Ongoing Inflation © 2001 South-Western, a division of Thomson Learning

Expectations and Ongoing Inflation When inflation continues for some time, the public develops expectations that the inflation rate in the future will be similar to the inflation rates of the recent past. © 2001 South-Western, a division of Thomson Learning

Expectations and Ongoing Inflation A continuing, stable rate of inflation gets built into the economy. The built-in rate is usually the rate that has existed for the past few years. © 2001 South-Western, a division of Thomson Learning

Expectations and Ongoing Inflation In an economy with built-in inflation, the AS curve will shift upward each year, even when output is at full employment and unemployment is at its natural rate. The upward shift of the AS curve will equal the built-in rate of inflation. © 2001 South-Western, a division of Thomson Learning

Expectations and Ongoing Inflation In the short run, the Fed can bring down the rate of inflation by reducing the rightward shift of the AD curve, but only at the cost of creating a recession. © 2001 South-Western, a division of Thomson Learning

Expectations and Ongoing Inflation Phillips Curve A curve indicating the Fed’s choice between inflation and unemployment in the short run. © 2001 South-Western, a division of Thomson Learning

Expectations and Ongoing Inflation In the short run, the Fed can move along the Phillips curve by adjusting the rate at which the AD curve shifts rightward. When the Fed moves the economy downward and rightward along the Phillips curve, the unemployment rate increases, and the inflation rate decreases. © 2001 South-Western, a division of Thomson Learning

Expectations and Ongoing Inflation In the long run, a decrease in the actual inflation rate leads to a lower built-in inflation rate, and the Phillips curve shifts downward. © 2001 South-Western, a division of Thomson Learning

Expectations and Ongoing Inflation In the short run, there is a trade-off between inflation and unemployment: The Fed can choose lower unemployment at the cost of higher inflation, or lower inflation at the cost of higher unemployment. But in the long run, since unemployment always returns to its natural rate, there is no such trade-off. © 2001 South-Western, a division of Thomson Learning

Expectations and Ongoing Inflation In the long run, monetary policy can change the rate of inflation, but not the rate of unemployment. © 2001 South-Western, a division of Thomson Learning

Expectations and Ongoing Inflation Long-Run Phillips Curve A vertical line indicating that in the long run, unemployment must equal its natural rate, regardless of the rate of inflation. © 2001 South-Western, a division of Thomson Learning

Expectations and Ongoing Inflation The long-run Phillips curve is a vertical line at the natural rate of unemployment. The Fed can select any point along this line in the long run, by using monetary policy to speed or slow the rate at which the AD curve shifts rightward. © 2001 South-Western, a division of Thomson Learning

Expectations and Ongoing Inflation The Fed has tolerated measured inflation of 2 to 3 percent per year because it knows that the true rate of inflation is lower, because low rates of inflation may help labor markets adjust more easily, and because there is not much payoff to lowering inflation further. © 2001 South-Western, a division of Thomson Learning