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 - π_T)
Aggregate output and potential output: (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.
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.