Monetary Policy Theory

Monetary Policy Theory

Preview of Chapter 24

  • Focus: Monetary Policy Theory.

Introduction

  • We will apply economic models (IS curve, MP curve, AD-AS-LRAS analysis) to analyze if monetary policy helps the economy based on different types of shocks.

Response of Monetary Policy to Shocks

  • The central bank aims to minimize the difference between:
    • Inflation and the inflation target: (π−πT)(π - π_T)
    • Aggregate output and potential output: (Y−YP)(Y - Y_P)
  • These gaps are often created by:
    • Aggregate demand shock
    • Temporary aggregate supply shock
    • Permanent aggregate supply shock
  • The responses of central bank’s monetary policies to these three different types of shock will be discussed.

Response to an Aggregate Demand Shock

  • Example: Decrease in aggregate demand due to disruption in financial markets.
  • Impact: AD curve shifts left, creating a lower inflation rate and lower output level.
  • Policy options:
    • No policy response
    • Policy stabilizes economic activity and inflation in the short run
No Policy Response
  • Expected inflation declines due to the lower inflation rate and output level.
  • This shifts AS curve to the right (back to the potential output level).
  • Disadvantages:
    • Output gap for a period of time.
    • Lower than target inflation rate discourages current consumption due to expectation of lower prices in the future.
Policy Stabilizes Output and Inflation in the Short Run
  • Expansionary monetary policy stabilizes economic activity and inflation.
  • Central bank reduces real interest rate, shifting AD back to the original level.
  • Advantages:
    • No tradeoff between price stability and economic activity stability (divine coincidence).

Response to a Temporary Supply Shock

  • Example: Increase in oil price.
  • Impact: AS curve shifts left, resulting in higher inflation and lower output level.
  • Policymakers face a short-run tradeoff between stabilizing inflation and economic activity.
  • Policy options:
    • No policy response
    • Policy stabilizes inflation in the short run
    • Policy stabilizes economic activity in the short run
No Policy Response
  • Output level is lower than the potential level, so expected inflation will decline.
  • This shifts AS curve to the right (back to the potential output level).
  • Disadvantages:
    • Painful period of higher inflation and low output.
Short-Run Inflation Stabilization
  • Contractionary monetary policy stabilizes inflation in the short run.
  • Central bank increases real interest rate, shifting AD to the left.
  • This moves inflation rate back to the target level, but the output is still lower than potential output.
  • Expected inflation decreases, shifting AS back to the original level.
  • Central bank needs to reverse the monetary policy, shifting AD back to the original.
  • Disadvantage:
    • Large deviation from potential output further for a period of time.
Short-Run Output Stabilization
  • Expansionary monetary policy stabilizes output in the short run.
  • Central bank reduces real interest rate, shifting AD to the right.
  • This moves output level back to the potential level, but the inflation rate increases further.
  • Disadvantage:
    • Large deviation from target inflation rate permanently.

Response to a Permanent Supply Shock

  • Example: New production regulation.
  • Impact: LRAS curve shifts left, resulting in a lower potential output level.
  • Current output level is higher than the potential output level, so people expect a higher inflation rate, creating an AS shock.
  • AS curve shifts to the left, resulting in higher inflation rate and a lower output level.
  • Policy options:
    • No policy response
    • Policy stabilizes inflation
No Policy Response
  • Output level is still higher than the potential level, so expected inflation rate continues to increase, shifting AS curve further to the left.
  • This increases inflation rate further and eventually lowers output level to the potential output.
  • Disadvantages:
    • A big increase in inflation over time.
Policy Stabilizes Inflation
  • Contractionary monetary policy stabilizes inflation.
  • Output level is still higher than the potential level, so central bank increases real interest rate, shifting AD to the left.
  • This moves inflation rate back to the target and lowers output level to reach the potential level quickly.
  • Advantages:
    • The target inflation rate is maintained

The Bottom Line: The Relationship Between Stabilizing Inflation and Stabilizing Economic Activity

  • Conclusions:
    • If most shocks are aggregate demand shocks or permanent aggregate supply shocks, then policy that stabilizes inflation will also stabilize economic activity, even in the short run.
    • If temporary supply shocks are more common, then a central bank must choose between the two stabilization objectives in the short run.

How Actively Should Policy Makers Try to Stabilize Economic Activity?

  • Economists generally agree on policy goals (high employment and price stability), but disagree on the best approach.
  • Activists: Believe government should pursue active policy to eliminate high unemployment.
  • Nonactivists: Believe government action is unnecessary to eliminate unemployment.

Lags and Policy Implementation

  • Lags prevent policy makers from shifting the aggregate demand curve instantaneously:
    • Data lag: Time to obtain data.
    • Recognition lag: Time to be sure of what the data are signaling.
    • Legislative lag: Time to pass legislation.
    • Implementation lag: Time to change policy instruments.
    • Effectiveness lag: Time for the policy to have an impact.

Causes of Inflationary Monetary Policy

  • High employment targets and inflation:
    • Cost-push inflation: Results from a temporary negative supply shock or wage hikes beyond productivity gains.
    • Demand-pull inflation: Results from policies that increase aggregate demand.

Part 1 Conclusion

  • We used the AD-AS framework to analyze the impact of government policies on the economy.
  • We also studied the different types of lags in government policies and two types of inflation.

Weekly Reading and Preparation

  • Read Chapters 24 and 25.
  • Prepare seminar problem answers for the seminar discussion after the reading week.