Transcript ECONOMICS - University of Maryland, College Park

CHAPTER
Inflation and Monetary Policy
Chapter 16
1
Inflation and Monetary Policy
• In 1970s inflation was as high as 13
percent - public very concerned.
• 1991 to 2008, inflation was around 2.5
percent.
• 2009 to 2011, recession, deflation a
major concern
• Inflation currently about 1.5%
2
Inflation and Monetary Policy
• Why was inflation high?
• How was it reduced?
• Why is deflation a concern?
3
Two Main Objectives of Monetary Policy –
The Federal Reserve’s Dual Mandate
1. Low, stable inflation
2. Full Employment
• Unstable inflation
•
Nominal interest rate = real interest rate +
inflation
• Adds to the risk of lending and borrowing
• Interferes with long-run financial planning
• Prefer 3% constant rate to 5 half the time and
1% the other half
4
Two Main Objectives of Monetary Policy –
Dual Mandate
• Full employment
– reduce cyclical unemployment to zero
• Concerns about cyclical unemployment
– opportunity cost
• The output that the unemployed could have
produced if they were working
– social cost/social failure
• causes significant hardship
5
The Objectives of Monetary Policy
• Natural rate of unemployment
– unemployment rate when there is no
cyclical unemployment
• Measured as sum of frictional and
structural unemployment
• The Fed can not affect the natural rate
– determined by supply and demand in the
labor market
6
The Objectives of Monetary Policy
• When unemployment rate < natural rate
– GDP is greater than potential output
– Economy’s self-correcting mechanism will
then create inflation.
– Look at graphs from chapter 15
• When unemployment rate > natural rate
– GDP is below potential output
– Economy’s self-correcting mechanism will
then put downward pressure on the price
level
– Graphs from chapter 15
7
Unemployment Rate < Natural Rate
Price
Level
Long-Run AS Curve
AS2
AS1
L
P4
P2
P1
N
E
AD2
AD1
YFE
Y2
After the positive
demand shock and all
the long-run adjustments
to it, the economy ends
up at point L with a
higher price level (P4),
but the same fullemployment output level
(YFE).
Economy’s selfcorrecting mechanism
will create inflation.
Real GDP
8
The Fed’s Performance - Inflation: 1950 to Present
2%
9
The Fed’s Performance - Unemployment: 1950 to
2011
6%
Less success for unemployment compared to
inflation
10
Federal Reserve Policy – Theory and Practice
• Simplifying assumptions
– let’s assume the Fed’s goal for the
inflation rate is zero
– Over the long run, the Fed succeeds in
achieving this goal
• NOTE: Fed’s goal is actually 2% inflation
11
Federal Reserve Policy – Theory and Practice
• Three possible Fed responses to demand
shocks
– Hold the money supply constant.
– Maintaining the interest rate i.e., hold the
interest rate constant.
– Neutralize (offset) the shock
• The first 2 responses are poor policies if
the economy is at or approaching full
employment!
12
Federal Reserve Policy -Theory and Practice
• Case 1 - Fully employed economy
experiences a positive demand shock and
Fed’s policy is constant money supply
target
• Call this the “do nothing” policy.
• Wait and let the economy self-correct
13
A Positive Demand Shock with a Constant Money Supply Short-run
Interest Rate
Price Level
(a)
AS
LRAS
MS
7%
(b)
B
H
5%
110
A
M2 d
M1 d
Money
F
E
100
AD2
AD1
FE =10.0 11.5 12.5
Real GDP $ Trillions
AD curve shifts rightward to AD2 , causing both the price level and output to
rise. If the Fed maintains a constant money supply, the rise in the price level
causes the money demand curve to shift to M2d in panel (a), driving the interest
rate up from 5 percent to 7%. A higher interest rate causes some crowding out
of consumption and investment spending, but not complete crowding out. In
panel (b), output increases the price level rises as well (point H).
14
A Positive Demand Shock with a Constant Money Supply Long Run
Price Level
Output will overshoot
its potential in the
short run
AS
120
K
H
110
Price level will rise in
the short run (to 110)
F
E
100
AD2
AD1
Price level will rise
further in the long run
(to 120)
FE =10.0 11.5 12.5
Real GDP $ Trillions
Output returns to FE.
15
Federal Reserve Policy -Theory and Practice
• Case 2 - Fully employed economy
experiences a positive demand shock and
Fed’s policy is constant interest rate.
• In this case, things are worse:
• An even greater overshooting of potential
output than a constant money supply
• An even greater rise in the price level –
more inflation!
16
A Positive Demand Shock with a Constant Interest Rate
Interest Rate
Price Level
(a)
M1S
M2S
(b)
AS
150
J
130
5%
A
C
M2d
110
100
AD3
E
AD2
M1d
AD1
Money
FE= 10.0
12.5
Real GDP ($ trillions)
AD curve shifts rightward to AD2 causing both price level and output to rise. The rise in the
price level shifts the money demand curve rightward to M2d in panel (a), which would
ordinarily cause the interest rate to rise. But if the Fed holds a constant interest rate target,
it will increase the money supply to prevent any rise in the interest rate. There will be no
crowding out of consumption or investment, so the AD curve in panel (b) shifts farther
rightward (to AD3 ). As a result, the economy ends up at point J, with output and the price
17
level rising by more than under a constant-money-supply policy.
A Positive Demand Shock with a Constant Interest Rate
Price level will rise in
the short run (to 130)
Price level will rise
further in the long run
(to 150)
Price Level
(b)
AS
150
J
130
110
100
AD3
E
AD2
Output returns to FE.
AD1
FE= 10.0
Have higher inflation
in the SR and the LR
12.5
Real GDP ($ trillions)
18
Federal Reserve Policy -Theory and Practice
• Case 3 - Fully employed economy
experiences a demand shock
• Fed’s best policy is to offset the demand
shock – neutralize it.
• To prevent any shift in AD, the Fed must
change its interest rate target
• A positive demand shock
– Requires an increase in the interest rate target
• A negative demand shock
– Requires a decrease in the interest rate target
19
A Positive Demand Shock Neutralized by Monetary Policy
Interest Rate
Price Level
(a)
M2
9%
5%
S
M1
(b)
S
AS
D
E
A
100
AD2
AD1
M1 d
Money
10.0
Real GDP ($ trillions)
A positive demand shock begins to shift the AD curve rightward in panel (b), which would
ordinarily cause both the price level and output to rise. But the Fed can neutralize the
shock by increasing its interest rate target enough to cause complete crowding out of
consumption and investment spending. The Fed must decrease the money supply in panel
(a), moving the money market equilibrium to a point like D. This reverses (or prevents) the
shift in the AD curve, so the economy ends up at point E in panel (b), at its initial output
20
and price level.
Federal Reserve Policy 2004 -2006
• From June 2004 to June 2006 the Fed felt
the economy was growing too rapidly (AD
shifting to the right too rapidly)
• The Fed increased its federal fund rate
target 17 times in 2 years from 1% to
5.25%.
21
Federal Funds Target Rate
22
Use of Monetary Policy to Offset A Negative Demand Shock
Interest Rate
Price Level
(a)
M1
5%
3%
(b)
S
AS
E
A
100
D
AD1
AD2
M1 d
Money
10.0
Real GDP ($ trillions)
A negative demand shock begins to shift the AD curve leftward in panel (b), which would
ordinarily cause both the price level and output to fall. But the Fed can neutralize the
shock by decreasing its interest rate target enough to cause complete crowding in of
consumption and investment spending. The Fed must increase the money supply in panel
(a), moving the money market equilibrium to a point like D. This reverses (or prevents) the
shift in the AD curve, so the economy ends up at point E in panel (b), at its initial output
23
and price level.
Federal Reserve Policy
• Beginning in September 2007 the Fed
decreased its federal funds rate target 10
times from 5.25% to 0.25% in 15 months
trying to offset the negative demand shock
resulting from the fall in housing prices
• Managing AD by changing the federal
funds rate is not an easy task. Easier said
than done!
24
Policy Dilemma for the Federal Reserve
• Negative supply shock (stagflation):
– if the Fed tries to preserve price stability
• It will worsen unemployment
• Inflation ‘hawks” focus on inflation
– if the Fed tries to maintain high employment
• It will worsen inflation
• Inflation “doves” not that concerned about
inflation when unemployment is rising
25
Policy Dilemma - Responding to Negative Supply
Shock
Price
Level
AS2
AS1
V
P3
R
P2
ADno recession
T
P1
E
AD1
ADno inflation
Y3
Y2
YFE
Real GDP
Starting at point E, a negative supply shock shifts the AS curve to AS2. With a constant
money supply, new short-run equilibrium would be established at point R, with a higher
price level (P2) and lower level of output(Y2). The Fed could prevent inflation by decreasing
the money supply and shifting AD to ADno inflation, but output would fall to Y3. At the other
extreme, it could increase the money supply and shift the AD curve to ADno recession. This
would keep output at the full-employment level, but at the cost of a higher price level, P3. 26
Federal Reserve Policy
• A negative supply shock presents the Fed
with a short-run tradeoff:
– It can limit the recession, but only at the
cost of more inflation (dove policy)
– It can limit inflation, but only at the cost of
a deeper recession (hawk policy)
• What about the economy’s self-correcting
mechanism?
27
Central Bank Policy
• US - Dual mandate
• European Central Bank and the Bank of
England - Price stability is the primary
mandate.
28
Inflation Expectations and Ongoing Inflation
• How ongoing inflation arises
– 1960s: series of positive demand shocks
– C and I increasing. G increasing (Vietnam
and Johnson’s War on Poverty)
– unemployment very low, close to 3%
• Fed policy was to maintain low interest
rates
– What effect does this have on AD?
– What effect would the economy’s selfcorrecting mechanism have had?
• Dr. Neri will draw a pretty graph now.
29
Inflation Expectations and Ongoing Inflation
• When inflation continues for some time
– the public develops expectations that
inflation will continue
– inflation gets built into the economy
– Great quote : “We have inflation because
we expect it, we expect inflation because
we have it”.
30
Inflation Expectations and Ongoing Inflation
• Once there is built-in inflation
– the economy continues to generate inflation
– even after the self-correcting mechanism has
finally been allowed to do its job and bring us back
to potential output
• Why?
– the AS curve will shift upward each year
• Workers expect higher prices and demand higher
nominal wages
• Suppliers require higher prices
31
Economy at Full Employment with Built-In Inflation
Price
Level
AS2
AS1
B
P2
A’
AD2
P1
A
AD1
YFE
Real GDP
During the year, the aggregate supply curve shifts upward by the built-in rate of
inflation. To keep the economy at full employment, the Fed shifts the AD curve
rightward by increasing the money supply. The economy goes to point B.
Does the process stop here?
32
Ongoing Inflation and the Phillips Curve
• Phillips curve
– A curve indicating the Fed’s choices
between inflation and unemployment in the
short run
33
The “Original” Phillips Curve
• Developed in 1958 by A.W. Phillips.
• Plotted the relationship he observed in
data between the % change in money
wages and the unemployment rate.
• Used the years: 1861-1957
• Used data from the UK
The “Modern” Phillips Curve
• Plots the inflation rate against the
unemployment rate.
• Recall: the inflation rate is the
percentage change in the price level.
• The Phillips Curve plots the inflation
rate on the vertical axis and the
unemployment rate on the horizontal
axis.
The Short-Run Relationship Between the
Unemployment Rate and Inflation
•Historical perspective
•During the 1960s,
there seemed to be an
obvious trade-off
between inflation and
unemployment. Policy
debates during the
period revolved around
this apparent trade-off.
Demand-Side (Demand Pull) Inflation and
the Phillips Curve
• If the change in real GDP is primarily caused
by a change in AD:
• Higher rates of inflation will be associated with
lower rates of unemployment
• Lower rates of inflation will be associated with
higher rates of unemployment
• The U.S. data for the 1960’s on the previous slide
shows such a relationship.
Supply-Side (Cost Push) Inflation and the
Collapse of Phillips Curve
• If  GDP is primarily caused by AS:
• Higher rates of inflation will be associated with
higher rates of unemployment
• Lower rates of inflation will be associated with
lower rates of unemployment
• The U.S. data for the 1970s on show such
a relationship.
The Short-Run Relationship between the Unemployment Rate and Inflation
•The Phillips Curve: A Historical
Perspective
From the 1970s
on, it became
clear that the
relationship
between
unemployment
and inflation
was anything
but simple.
The Phillips Curve: A Historical Perspective 1950’s1960’s and 1970’s - early 1980’s
The Phillips
Curve
shifted up.
•12%
•11
•10
•1974 •1980
Why?
•Inflation Rate
•9
•1979
•8
•1973 •1978
•7
•1977
•1968
•6
•1969
•5
•3
•2
•1
•0
•1971
•1972
•1976
•1970
•1982
•1966
•1984
•1956 •1955
•1965•1954
•1957
•1962
•1967
•1959 •1958
•1964
•1961
•1960
•1963
•4
Inflation
expectations
•1981
•1975
•1
•2
•3
•4
•5
•6
•7
•8
•1983
•9
•Unemployment Rate in Percent
•10
Inflation Expectations and the Phillips Curve
• If inflationary expectations increase
• the result will be an increase in the
rate of inflation even though the
unemployment rate may not have
changed.
• There will be more inflation at any
given level of the unemployment rate.
• In this case, the Phillips Curve will
shift up (to the right).
The Phillips Curve Shifts Upward
Inflation
Rate
9%
J
E
6%
PCbuilt-in expected inflation
= 9%
PCbuilt-in expected inflation
= 6%
UN
Unemployment
Rate
42
Inflation Expectations and the Phillips Curve
• If inflationary expectations decrease,
• the result will be a decrease in the rate
of inflation even though the
unemployment rate may not have
changed.
• There will be less inflation at any given
level of the unemployment rate.
• The Phillips Curve will shift down (to the
left)
The Phillips Curve Shifts Downward
Inflation
Rate
E
6%
3%
G
PCbuilt-in expected inflation
= 6%
PCbuilt-in expected inflation
= 3%
UN
Unemployment
Rate
44
The Phelps/Friedman “Take”
• Two famous economists:
– Edmund Phelps (1967)
– Milton Friedman (1968)
• Downward sloping Phillips Curve is only
a SR concept.
• In the LR the Phillips Curve is vertical at
Un - the natural rate of unemployment.
• Expectations play a key role.
Expectations are self-fulfilling:
• Wage inflation is affected by expectations
of future price inflation, since workers care
about real wages!
• Price expectations that affect wage
contracts eventually affect prices
themselves.
• Inflationary expectations shift the SR
Phillips Curve upward.
The Phillips Curve: A Historical Perspective 1950’s1960’s and 1970’s - early 1980’s
•12%
•11
•10
•1974 •1980
•9
•Inflation Rate
The Phillips
Curve
shifted up.
Inflation
expectations
were stable
on the 50s60s , but
increased in
the 70s-80s.
•1979
•8
•1973 •1978
•7
•1977
•1968
•6
•1969
•5
•1971
•1972
•1976
•1970
•1982
•1966
•1984
•1956 •1955
•1965•1954
•1957
•1962
•1967
•1959 •1958
•1964
•1961
•1960
•1963
•4
•3
•2
•1
•0
•1981
•1975
•1
•2
•3
•4
•5
•6
•7
•8
•1983
•9
•Unemployment Rate in Percent
•10
Vertical AS Curve and the Vertical Phillips Curve
•Vertical
•Inflation Rate
•Price Level
•AS
•Vertical
•long-run
•Phillips
•curve
•long-run aggregate
•supply
•curve
•Yf
•Real GDP
•U*
•Unemployment Rate
•(a)
•(b)
Contractionary Monetary Policy and The
Phillips Curve
Inflation
Rate
At E, the economy is in long-run
equilibrium: unemployment at its
natural rate (UN) and inflation at the
built-in rate (6%).
E
6%
F
3%
To reduce the inflation rate to 3%,
the Fed must accept higher
unemployment (U1) in the short
run.
PCbuilt-in expected inflation
= 6%
UN
U1
Unemployment Rate
49
Expectations and Ongoing Inflation
• In the previous slide, the Fed
– moves the economy downward and
rightward along the Phillips curve
• the unemployment rate increases
• and inflation rate decreases
• A decrease in the inflation rate in the long
run
– lowers built-in inflationary expectations
– and the Phillips curve shifts downward
50
The Phillips Curve
Inflation
Rate
E
6%
3%
G
UN
Initially, the economy is at
point E, with inflation
Shifts Downward
equal to the built-in rate of
6%. If the Fed moves the
economy to point F and
keeps it there for some
time, the public will
eventually come to expect
3% inflation in the future.
The built-in inflation rate
F
will fall and the Phillips
curve will shift downward
PCbuilt-in inflation to PC
built-in inflation = 3%. The
= 6%
economy will move to
point G in the long run,
PCbuilt-in inflation
with unemployment at the
= 3%
U1
Unemployment natural rate and an actual
inflation rate equal to the
Rate
built-in rate of 3%
51
Expansionary Monetary Policy - The Phillips
Initially, the economy is at
Curve
Shifts
Upward
Inflation
Rate
9%
H
J
E
6%
U2
UN
point E, with inflation equal
to the built-in rate of 6%. If
the Fed moves the
economy to point H and
keeps it there for some
time, the public will
eventually come to expect
9% inflation in the future.
PCbuilt-in inflation The built-in inflation rate
will rise and the Phillips
= 9%
curve will shift upward to
PCbuilt-in inflation
PCbuilt-in inflation = 9%. The
= 6%
economy will move to point
UnemploymentJ in the long run, with
unemployment at the
Rate
natural rate and an actual
inflation rate equal to the
built-in rate of 9%.
52
Expectations and Ongoing Inflation
• In the Long run there is no tradeoff
– Unemployment always returns to its
natural rate
• Long-run Phillips curve
– A vertical line
– In the long run, unemployment must equal
its natural rate
– Regardless of the rate of inflation
53
The Long-Run Phillips Curve The vertical line is the
Inflation
Rate
9%
6%
3%
economy’s long-run Phillips
curve, showing all
Long-Run Phillips Curve
combinations of
unemployment and inflation
J
H
the Fed can choose in the
long run. The curve is
vertical because in the long
E
PCbuilt-in inflation run, the unemployment rate
must equal the natural rate.
= 9%
Starting at point E with 6%
G
F
PCbuilt-in inflation inflation, the Fed can
choose unemployment at
= 6%
the natural rate with either a
PCbuilt-in inflation
= 3%
higher rate of inflation (point
U2
UN
U1 Unemployment J ) or a lower rate of
inflation (point G ). But
Rate
points off of the vertical line
are not sustainable in the
long run.
54
Why does the Fed Allow Ongoing Inflation?
• The Fed has tolerated measured inflation
at about 2 percent per year because:
– It knows that the true rate of inflation is
lower (measurement problem)
– Ongoing inflation may help labor markets
adjust more easily.
• Suppose excess supply of labor and real
wage needs to fall 3% in an industry – can
happen 2 ways – nominal wage falls or prices
increase. If P ↑ => (W/P) ↓
55
Why does the Fed Allow Ongoing Inflation?
• The Fed has tolerated measured inflation
at 2 percent per year because:
– Ongoing inflation gives the Fed more
flexibility to bring down real interest rates
– Real interest rate = nominal rate - inflation
56
Challenges for Monetary Policy
• Information problems
– Uncertain and varying time lags
• Policies meant to stabilize the economy
could instead destabilize it
• It takes up to 1 years for a change in the
money supply to affect real GDP.
• It takes about 1 year for a change in real
GDP to affect the rate of inflation
57
Challenges for Monetary Policy
• Information problems
– Uncertainty about natural rate of
unemployment
• Natural rate is an estimate.
• If the Fed believes the natural rate of
unemployment is 4.5% but its actually
5%, the Fed will overheat the economy
and raise the inflation rate.
58
Challenges for Monetary Policy
• Rules versus discretion
– Following a rule could help the Fed
manage inflationary expectations
• Make it easier to take actions
– Beneficial in the long run
– Unpopular in the short run
• Taylor rule – proposed rule:
– Require the Fed to change the interest
rate by a specified amount
• When real GDP or inflation deviates from
target
59
THE COST OF REDUCING INFLATION
• To reduce inflation, an economy must
endure a period of high unemployment
and low output.
• When the Fed combats inflation, the
economy moves down the short-run
Phillips curve.
• The economy experiences lower
inflation but at the cost of higher
unemployment.
THE COST OF REDUCING INFLATION
• Would the Fed ever create a recession to
kill inflation expectations?
• YES! Paul Volcker 1979 – 1982.
61
The Volcker Disinflation
• When Paul Volcker became Fed
chairman in 1979, inflation was widely
viewed as one of the nation’s foremost
problems.
• Volcker succeeded in reducing inflation
(from 10 percent to 4 percent), but at the
cost of high employment (about 10
percent in 1983).
The Fed’s Performance - Inflation: 1950 to Present
2%
63
The Fed’s Performance - Unemployment: 1950 to
2011
6%
Less success for unemployment compared to
inflation
64
The Volcker Disinflation
•Inflation Rate
•(percent per year)
10
•1980 •1981
•A
•1979
8
•1982
6
•1984
4
•1987
•C
2
0
1
2
3
4
5
6
•B
•1983
•1985
•1986
7
8
9
10 Unemployment
Rate (percent)
•Copyright © 2004 South-Western
The Volcker Disinflation
•Inflation Rate
•(percent per year)
LRPC
10
•1980 •1981
•A
•1979
8
•1982
6
PCbuilt-in inflation
= 9%
•1984
4
•1987
•C
2
•B
•1983
•1985
PCbuilt-in inflation
= 7%
•1986
PCbuilt-in inflation
= 5%
PCbuilt-in inflation
= 4%
0
1
2
4
5
6
7
8
9
10 Unemployment
Rate (percent)
•Copyright © 2004 South-Western