Chapter 16: Monetary Policy - Detailed Notes

Chapter 16: Monetary Policy

Introduction

• Focus on three key questions regarding the Fed's influence on Aggregate Demand (AD):

  1. When should the Fed intervene to influence AD?

  2. When is the Fed capable of influencing AD?

  3. When will this influence lead to increased GDP growth?

Monetary Policy: The Best Case

• Best Case Definition: Clear guidelines for Fed's actions, but challenges exist.

• Negative Shock Example:

  • Description: Shock to AD driven by "animal spirits" (emotions such as fear).

  • Scenario: Economy growing at 3%, inflation at 7%.

  • Consumers become pessimistic:

  • Result: Decreased borrowing and spending.

  • Consequence: Shift of AD to the left leading to a decline in output growth.

Data Overview

• Inflation Rate () and GDP Growth Rates with changes in Monetary Policy:

  • Initial Conditions:

  • AD driven by (M + v) = 10%

  • After Shock: (M + v) = 5%

  • Policies:

  • Fed increases money supply (M) to boost AD and real GDP growth.

Recovery Mechanism

• Economic Recovery:

  • Eventually, fear subsides; economy returns to steady state growth.

  • Intermediate phase: rampant slow growth and increased unemployment, potentially recessionary.

Fed Actions During Recovery

• Monetary Policy Tools:

  • Increase growth rate of the money supply.

  • Reduce interest rates to stimulate borrowing.

• Monetary Shift Outcomes:

  • Shift up and right in AD curve leads to higher inflation and GDP growth.

Key Challenges in Monetary Policy

• Considerations:

  1. The Fed operates in real-time with limited data.

  2. Control over money supply is often incomplete due to uncertain lags (typically between 6-18 months).

• Impact of Money Supply Changes:

  • Changes in the money supply can be influenced by monetary multiplier effect.

  • Equation: \Delta MS = \Delta MB \times MM

Consequences of Overstimulating AD

• Historical Example (1970s):

  • Fed overstimulation led to an inflation spike (13.5% in 1980), followed by a severe recession (unemployment peak >10%).

• Disinflation Strategy:

  • Must be credible; workers need to anticipate slower wage growth to minimize layoffs.

Market Confidence and Its Role

• Importance of Market Confidence:

  • Fear and expectations significantly influence AD.

  • Fed's capacity to stabilize expectations can prevent recessions.

• 911 Response:

  • Post-terrorist attack confidence impacted investments, leading Fed to provide $45.5 billion in liquidity to stabilize markets.

Negative Real Shock Dilemma

• Impact of Negative Real Shock:

  • Shift of Long-Run Aggregate Supply (LRAS) causes inflation to rise and GDP growth to drop.

  • Policy Choices:

  • Decreasing M lowers inflation but further reduces GDP.

  • Increasing M raises GDP slightly but exacerbates inflation.

• Conclusion: Fed struggles to achieve dual mandate during negative real shocks.

Fed Overreaction in Late 1990s

• Fed's low Federal Funds rate (1% till 2004) promoted cheap credit, leading to housing bubble.

• Consequence: subsequent real estate crash led to financial market distress.

Identifying Asset Price Bubbles

• Challenges of Policy Adjustment:

  • Speculative bubbles are hard to identify and monetary policy uniformly affects the economy.

• Regulatory Solutions:

  • Fed could have regulated bank lending better to avoid bubble conditions.

Rules vs. Discretion in Monetary Policy

• Monetary Adjustment Conundrum:

  • Uncertainty about whether adjustments effectively reduce output volatility.

  • Some advocate for strict monetary rules to guide policy without reacting to each shock.

• Nominal GDP Rule Proposition:

  • Maintain a stable growth path for MV (money supply times velocity) to stabilize economic performance.