Ch. 16 Monetary Policy Notes

Introduction

• Focus on three key questions regarding the Federal Reserve (Fed) and aggregate demand (AD):

  • When should the Fed try to influence AD?

  • When can the Fed influence AD?

  • When does this influence result in higher GDP growth rates?

Monetary Policy: The Best Case

• A negative shock to AD can stem from "animal spirits" (emotions like fear).

• Economic conditions prior to the shock:

  • Growth rate: 3%

  • Inflation rate: 7%

• Effects of the shock:

  • Consumers borrow and spend less due to pessimism

  • Banks lend less; entrepreneurs invest less

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

• Recovery from the shock is slow, characterized by increased unemployment or recession.

• The Fed’s role:

  • Combat sluggish growth by adjusting monetary policy:

  • Increase the rate of growth of money supply

  • Reduce interest rates to encourage borrowing

Decreasing AD

• Risks of overstimulation by the Fed leading to excessive AD.

• Historical example:

  • 1970s inflation peaked at 13.5% due to overstimulation.

  • By 1983, monetary policy had reduced inflation but resulted in a severe recession (unemployment over 10%).

• Key concepts:

  • Disinflation: A significant reduction in the rate of inflation.

  • Deflation: A decrease in prices (negative inflation rate).

• Challenge of achieving disinflation:

  • Policy must be credible with flexible wage growth to mitigate negative unemployment effects.

Market Confidence

• Market Confidence: The Fed's influence over expectations is crucial for AD shifters (fear and confidence).

• Example: Post 9/11 actions by the Fed helped stabilize market expectations and restore confidence.

The Negative Real Shock Dilemma

• A real shock (e.g., rising oil prices) shifts the Long-Run Aggregate Supply (LRAS) curve left, increasing inflation but decreasing GDP growth.

• Fed responses:

  • Increasing the money supply can boost AD, but leads to further inflation without enhancing productivity.

• Central bank decisions must balance between high unemployment rates and high inflation.

When the Fed Does Too Much

• Historical case: Post-2001 recession and near-zero Federal Funds rate maintained from 2001 to 2004 resulted in a housing bubble.

• Low rates led to increased mortgage borrowing, culminating in a housing price crash and financial crisis.

• Policy Limitations: Difficulty in identifying asset bubbles and the limitations of monetary policy.

Rules vs. Discretion in Monetary Policy

• Some economists advocate for consistent rules rather than reactive adjustments to AD shocks.

• Nominal GDP targeting suggested as a potential policy framework to stabilize the economy.

Takeaways

• The Fed influences GDP growth and can restore AD through expansionary monetary policy post-negative shocks.

• However, the timing and impact of these policies are uncertain.

• Excessive increases in the money supply can lead to painful disinflation processes, resulting in recession.

• Balancing low inflation and low unemployment remains a key challenge for central banking, reflecting the blend of art and science in monetary policy.

Introduction
Focus on three key questions regarding the Federal Reserve (Fed) and aggregate demand (AD):

1. When should the Fed try to influence AD?

2. When can the Fed influence AD?

3. When does this influence result in higher GDP growth rates?

Monetary Policy: The Best Case
A negative shock to AD can stem from phenomena often described as "animal spirits," which refer to the emotions and psychological factors that impact consumer and investor behavior, such as fear and uncertainty.

Economic conditions prior to the shock include:

• Growth rate: 3%

• Inflation rate: 7%

Effects of the shock include:

• Consumers exhibit diminished confidence, leading to reduced borrowing and spending. This pessimism can exacerbate a downward economic spiral.

• Banks respond by tightening lending practices, further dampening entrepreneurial investment.

• Cumulatively, these effects shift AD to the left, resulting in a significant decline in output growth.

• Recovery from the shock is typically slow and fraught with challenges, often leading to increased unemployment levels or potential recession.

The Fed’s role is pivotal during such periods:

• It combats sluggish growth by adjusting monetary policy, which may involve:

  • Increasing the rate of growth of the money supply to stimulate economic activity.

  • Reducing interest rates to encourage borrowing and spending, thus aiming to shift AD back to the right.

Decreasing AD
There are inherent risks associated with overstimulation by the Fed, particularly leading to excessive AD.
Historical examples underline these risks, notably the inflation crisis of the 1970s, which peaked at 13.5% due to excessive monetary expansion.
By 1983, the Fed had implemented a restrictive monetary policy that successfully reduced inflation but also resulted in a severe recession, with unemployment rates soaring above 10%.

Key concepts include:

• Disinflation: A significant reduction in the rate of inflation, crucial for restoring price stability without inducing a recession.

• Deflation: A decrease in the general price level of goods and services, which can exacerbate economic downturns through reduced consumer spending and increased real debt burdens.

The challenge of achieving disinflation necessitates credible policy actions combined with conditions for flexible wage growth, which can help mitigate the adverse effects on unemployment.

Market Confidence
Market confidence plays a critical role in the Fed's ability to influence expectations, which are essential shifters of AD.
For instance, actions taken by the Fed after the attacks on September 11, 2001, are a prime example of how effective communication and policy can stabilize market expectations and restore investor and consumer confidence in the economy.

The Negative Real Shock Dilemma
A real shock, exemplified by rising oil prices, can cause the Long-Run Aggregate Supply (LRAS) curve to shift leftward. This shift typically results in increased inflation while simultaneously decreasing GDP growth, creating a challenging economic landscape.

Fed responses may include:

• Increasing the money supply to potentially boost AD; however, this strategy carries the risk of further inflating prices without enhancing overall productivity.

• The central bank must navigate a delicate balance between counteracting high unemployment rates and managing inflationary pressures.

When the Fed Does Too Much
A historical illustration of the pitfalls of excessive monetary policy is observed in the period after the 2001 recession when the Federal Reserve maintained a near-zero Federal Funds rate from 2001 to 2004.

• This prolonged period of low interest rates contributed to rampant mortgage borrowing, which ultimately led to a housing bubble.

• The housing market collapse triggered a significant financial crisis, highlighting the complexity and potential risks inherent in monetary policy strategy.

Policy limitations include the inherent difficulty in identifying asset bubbles and recognizing the constraints of monetary policy in addressing systemic economic failures.

Rules vs. Discretion in Monetary Policy
Some economists argue for the implementation of consistent rules as opposed to reactive measures in response to AD shocks.

• Nominal GDP targeting is proposed as a viable policy framework, aiming to stabilize the economy and promote sustainable growth by providing clear and predictable guidelines for monetary policy.

Takeaways
The Federal Reserve plays a crucial role in influencing GDP growth and can effectively restore AD through expansionary monetary policy following negative shocks.
However, the timing and long-term effects of such policies remain uncertain, necessitating careful consideration by policymakers.
Excessive increases in the money supply can lead to challenging disinflation processes that may culminate in recession.
Ultimately, balancing low inflation and low unemployment remains an ongoing challenge for central banking, illustrating the blend of art and science that defines effective monetary policy.

:An asset price bubble is a market phenomenon characterized by a significant and rapid increase in the prices of assets, such as stocks or real estate, driven primarily by speculation rather than fundamental value. During a bubble, prices can soar to levels that far exceed the intrinsic value of the underlying asset, often supported by excessive investor optimism and behavior that escalates market demand. Eventually, when reality sets in and investors recognize that prices are unsustainable, a sharp decline occurs, leading to a market crash known as a 'burst' of the bubble, which can result in significant financial losses and economic repercussions.

:An asset price bubble is a market phenomenon characterized by a significant and rapid increase in the prices of assets, such as stocks or real estate, driven primarily by speculation rather than fundamental value. During a bubble, prices can soar to levels that far exceed the intrinsic value of the underlying asset, often supported by excessive investor optimism and behavior that escalates market demand. Eventually, when reality sets in and investors recognize that prices are unsustainable, a sharp decline occurs, leading to a market crash known as a 'burst' of the bubble, which can result in significant financial losses and economic repercussions.

The phrase 'creates arbitrary redistributions of wealth' refers to economic policies or actions, particularly within monetary policy, that can lead to unplanned or unintended shifts in the distribution of wealth among different individuals or groups within an economy. This often occurs as a result of inflation, interest rate changes, or monetary stimulus which may benefit certain sectors, asset holders, or demographics disproportionately. For example, when the Fed increases the money supply, it may initially help borrowers and those with debt but can harm savers and fixed-income earners by eroding the value of their savings. Ultimately, the term suggests that wealth distribution resulting from such policies may not be based on merit or productivity but rather influenced by volatility in markets and economic conditions.

When prices are described as "sticky," it refers to the phenomenon where prices do not adjust quickly to changes in demand or supply. This can occur in both upward and downward directions. For instance:

• Upward Stickiness: Prices often increase slowly due to factors such as contracts, customer reluctance to accept higher prices, or attempts to maintain customer loyalty.

• Downward Stickiness: Prices may not decrease easily even when demand falls, as businesses prefer to maintain profitability and avoid upsetting customers who have already been accustomed to certain prices.

Sticky prices can lead to situations where markets are not as responsive as they might be to economic conditions, which can result in prolonged periods of shortages or oversupply.

Negative shocks refer to unexpected events or economic changes that adversely affect demand or supply, leading to decreased economic performance or growth. Examples include sudden declines in consumer confidence or natural disasters that disrupt production. Real shocks, on the other hand, pertain specifically to shifts that impact the economy's productive capacity or supply side. An example of a real shock is rising oil prices, which can shift the Long-Run Aggregate Supply (LRAS) curve leftward, increasing inflation while decreasing GDP growth. This creates a challenging economic environment, necessitating careful policy responses to balance unemployment and inflation.

To subsidize means to support or provide financial assistance to an individual, organization, or industry, typically by the government or a public body. This support can help reduce the costs of goods or services, encourage production, and make certain activities more accessible. Subsidies can take various forms, including direct payments, tax breaks, or grants, and are often used in sectors like agriculture, education, and healthcare to promote social welfare or economic growth.

GDP volatility refers to the fluctuations or variations in the Gross Domestic Product (GDP) of a country over a specified period. These fluctuations can signify periods of economic growth followed by contractions or recessions. Factors contributing to GDP volatility include changes in consumer spending, investment levels, government policies, and external shocks such as financial crises or natural disasters. High GDP volatility can indicate an unstable economy, which may lead to uncertainty for businesses and consumers, affecting overall economic confidence.

Volatility refers to the degree of variation or fluctuation in the price or value of an asset, market, or economic indicator over time. It indicates how much and how quickly the value of an asset can change. High volatility signifies larger price swings and greater uncertainty, while low volatility indicates more stable prices. Volatility is a critical aspect in finance as it can affect investment decisions, risk assessment, and market behaviors.

Monetary aggregate M2 refers to a measure of the money supply that includes all elements of M1, such as cash and checking deposits, along with short-term savings deposits, time deposits under $100,000, and retail money market funds. M2 is used by economists to gauge the overall amount of money circulating in the economy and can provide insights into economic activity and inflation. It is often analyzed alongside M1 to understand liquidity and the potential for consumer spending