Inflation and Monetary Policy Chapter 16

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

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

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

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

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

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

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

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

The Fed’s Performance - Unemployment: 1950 to 2011 6% Less success for unemployment compared to inflation

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

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!

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

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).

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

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

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.

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

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.

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%.

Federal Funds Target Rate

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.

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!

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”

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.

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?

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

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.

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”.

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

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?

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

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: 1861-1957 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.

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.

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.

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.

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 1972-1974 and 1978-1980 show such a relationship.

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.

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

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).

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

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)

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

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.

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.

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

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

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

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

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

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

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

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) ↓

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

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

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.

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

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.

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

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).

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 © 2004 South-Western

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 © 2004 South-Western