Monetary Policy Notes

Monetary Policy

Previously

  • Money includes currency and bank deposits.
  • Banks expand the money supply by extending loans.
  • The Fed's job of monitoring the money supply is difficult.
  • The Fed acts as the bank for other banks and regulates them.

Monetary Policy

  • Expansionary: increase money supply.
  • Contractionary: decrease money supply.
  • Limitations.

Short Run vs. Long Run

  • Short Run: Some prices are inflexible and do not adjust immediately.
  • Long Run: A period of time long enough for all prices to adjust.
  • Monetary Policy: The Federal Reserve changes the money supply through open market operations.

Expansionary Monetary Policy

  • Expansionary Monetary Policy: When a central bank acts to increase the money supply to stimulate the economy.
  • Typically expands the money supply through open market purchases.
    • When the money supply increases, the supply of loanable funds increases.
    • Interest rates then fall.
    • Firms decide to invest.
    • Aggregate demand shifts right.

Real vs. Nominal Effects

  • Monetary policy can have real effects such as increasing output and reducing unemployment.
  • The new money devalues the entire money supply because prices rise.
  • In the long run, the real effects of monetary policy dissipate completely.
  • The only change in the long run is a higher price level.

The Real Value of Money as Prices Adjust

  • Unexpected Inflation Hurts Some People
    • If inflation is higher than expected, it hurts input suppliers that have sticky prices, workers who signed wage contracts and resource suppliers who are contracted to sell goods at a given price.
    • If inflation is lower than expected, it hurts demanders who signed a fixed-price contract, employers who create wage contracts, resources purchasers who signed long-term contracts to buy goods at certain prices.

Contractionary Monetary Policy

  • Contractionary Monetary Policy: When a central bank takes action that reduces the money supply in the economy.
  • Often done during times of rapid expansion to curb potential inflation.
  • The central bank reduces the money supply via open market sales.
  • Lower supply of loanable funds increases interest rates.
    • With higher interest rates, investment falls, shifting AD to the left.

Shortcomings of Monetary Policy

  • Monetary policy is limited in what it can accomplish.
    • Diminished effects in the long run.
    • Effects being reduced by people’s expectations.
    • Less effective if downturns are caused by AS, rather than AD.

Long-Run Effects of Monetary Policy

  • Monetary neutrality: The idea that the money supply does not affect real economic variables.
  • Because eventually all prices adjust, in the long run, monetary policy does not affect real GDP or unemployment.
  • Monetary policy does not affect the long run, many economists suggest that the Fed should instead focus on short-run issues such as smoothing out the business cycle.

Adjustments in Expectations

  • Unexpected inflation harms people.
  • People have an incentive to adjust and prepare for inflation.
  • Monetary policy has real effects only when some prices are sticky (when inflation is unexpected).
  • If inflation is expected, prices are not sticky; prices rapidly adjust because people plan on the inflation.

The Phillips Curve

  • Phillips curve: Indicates a short-run negative relationship between inflation and unemployment rates.
  • Two-part policy implication:
    • Less unemployment = higher inflation.
    • Lower inflation = higher unemployment.

Long-Run Phillips Curve

  • The Phillips Curve does not take into account the long run
  • The long-run Phillips curve is vertical. No long run trade off between Inflation/prizes and output or unemployment.

Adaptive Expectations

  • Adaptive expectations theory: People's expectations of future inflation are based on their most recent experience.
  • Expansionary monetary policy can stimulate the economy and reduce unemployment only if it is unexpected.

Rational Expectations

  • Rational expectations theory: People form expectations on the basis of all available Information.
  • Random errors rather than statistically biased errors.

A Modern View of the Phillips Curve

  • Suppose inflation is 0% and people expect 0% inflation in the future:
    • Unemployment is equal to the natural rate.
    • If inflation rises to 5%:
      • Unemployment will fall.
  • However, if people expect 5% inflation:
    • Inflation will not reduce unemployment.
    • The new levels of inflation shift the Phillips curve.

Implications for Monetary Policy

  • Active monetary policy: Strategic use of monetary policy to counteract macroeconomic expansions and contractions.
  • Passive monetary policy: Central banks purposefully choose only to stabilize money and price levels through monetary policy.
  • Does not seek to affect real variables such as unemployment and output.

Conclusion

  • Monetary policy can be expansionary or contractionary: Increasing or decreasing the money supply.
  • In the short run, monetary policy affects real GDP and unemployment.
  • In the long run, monetary policy affects only the price level.
  • Phillips curve: short-run inverse relationship between unemployment and inflation.
  • Rational expectations negate the effects of active monetary policy.