Required reading:

Ch 16

Lecture 17:
Monetary Policy, Inflation
Econ 201, Winter 2018

1 2/27/2018
What the Fed Wants, the Fed Gets
 In this story, the Fed can move AD to wherever it
wants

 It can do so much faster than Fiscal Policy

 No debate
 Investment is much more volatile than consumption
 Change course easily

 So AD is always wherever the Fed wants it

 Total Conquest of Recession! Fed can close any
Gap
What the Fed Wants, the Fed Gets
 That was the “triumphalist” view in 50s and 60s
 For good reason!
What the Fed Wants, the Fed Gets
 But in the 70s…
 What the Fed Wants, the Fed Gets

 Contractionary monetary policy is sometimes used to

eliminate inflation that has become embedded in
the economy.

 In this case, the Fed needs to create a recessionary

gap—not just eliminate an inflationary gap—to
wring embedded inflation out of the economy.

 That’s why it’s sometimes said the unemployment

rate is whatever the Fed wants it to be
Moderate Inflation and Disinflation

 In the short run, policies that produce a booming

economy also tend to lead to higher inflation,
and policies that reduce inflation tend to depress
the economy.

 This creates both temptations and dilemmas for

governments.
Monetary Policy
 Expanding the Money Supply can lower interest
rates and shift AD outward

 Can lead to more inflation, and speed up how

quickly SRAS shifts inwards, as wages rise

 Even larger increase in Money Supply needed to

do the same thing next time
Moderate Inflation and Disinflation

 In the short run, policies that produce a booming

economy also tend to lead to higher inflation,
and policies that reduce inflation tend to depress
the economy.

 This creates both temptations and dilemmas for

governments.
What About the Long Run?
 The Money supply was not part of the story in
chapter 9
 Can the Fed create growth forever?

 Or more precisely, why not just keep shifting AD

outwards?
 It would lead to higher prices, but that’s a small price
to pay for higher output.
 Most people would agree to having unemployment a
little lower and prices a little higher
 Why can’t that work?
Money, Output, and Prices in the Long Run
Aggregate
price level An increase in the
money supply reduces
the interest rate and
increases aggregate
demand . . . LRAS

SR AS
2
SRAS
1
E
P 3
3 . . . but the eventual
rise in nominal wages
P E leads to a fall in
2 2
short-run aggregate
P AD
1 E 2 supply and aggregate
1 AD output falls back to
1
potential output.

Y Y
1 2 Real GDP

Potential output
The Long-Run Determination of the Interest Rate
Interest
rate, r
MS
1

E
r 1
1

r
MD
1

M Quantity of money
1
THE EFFECTIVENESS OF MONETARY
POLICY
 If money supply increases, what happens?
 The increase in AD will increase the price level and output
and eventually pull up nominal wages, which moves the
SRAS curve leftward. LRAS
SRAS2
Aggregate
price level
SRAS1
E3
P3

P2 E2
E1
P1
AD2
AD1

Potential output YP Y1 Real GDP

C O P Y R I G H T 2 0 1 5 W O R T H P U B L I S H E R S
THE CLASSICAL MODEL OF THE
PRICE LEVEL
 The “classical” (pre-Keynes) model assumes the economy
moves directly from E1 to E3—not necessarily a good
assumption during normal times of low inflation.
LRAS
Aggregate SRAS2
price level
SRAS1
E3
P3

E1
P1
AD2
AD1

Potential output YP Y1 Real GDP

C O P Y R I G H T 2 0 1 5 W O R T H P U B L I S H E R S
 MONEY AND PRICES

 As we have established, an increase in the money

supply changes only prices in the long run.
 According to the classical model of the price level,
the real quantity of money is always at its long-run
equilibrium level.
 .

 where M = nominal money supply and P = price

level.

C O P Y R I G H T 2 0 1 5 W O R T H P U B L I S H E R S
Consumer Prices in Zimbabwe, 2000-2008
Money Supply Growth and Inflation in Zimbabwe
Hyperinflation
 Imagine a country with a large debt
 Ran a deficit for a number of years, G>T

 Now, there is fear it cannot pay back the debt

 Political opposition to cutting G or raising T

 Easy Solution: Print money and pay back the debt

 Government Debt is denominated in a currency that
government controls
Hyperinflation
 What happens?
 Money supply rises – a lot!
 SRAS shifts inwards quickly
 Rising nominal wages!
 Prices rise – a lot!

 Real purchasing power of money falls

 Reduces Money Demand
 Real value of taxes collected falls a lot
 Next year, even more inflation will be required.
 “Anything that can’t last forever, won’t” -
 Default, or painful cuts in G, rises in T loom
Hyperinflation
 This is one reason for a politically independent central bank

 Printing money and controlling the money supply used to

be government’s only real source of income

 Called “Seignorage”
 Revenue from the government’s right to print money
 IE, money is printed, prices rise, government debt is worth less,
so the government has more real purchasing power for other
things
 Or even explicitly printing money and buying things with it

 Nowadays we have the IRS, much more effective

 Seignorage less than 1% of gov’t revenue
The Inflation Tax

 The inflation tax is the reduction in the real

value of money held by the public caused by
inflation, equal to the inflation rate times the
money supply, on those who hold money.

 The real value of resources captured by the

government is reflected by the real inflation
tax, the inflation rate times the real money
supply.
 Real inflation tax = Seignorage
 The Logic of Hyperinflation

▪ To avoid paying the inflation tax, people reduce their

real money holdings and force the government to
increase inflation to capture the same amount of real
inflation tax.

▪ In some cases, this leads to a vicious circle of a

shrinking real money supply and a rising rate of
inflation.

▪ This leads to hyperinflation and a fiscal crisis.

Moderate Inflation and Disinflation

 The governments of wealthy, politically stable

countries like the United States and Britain
don’t find themselves forced to print money to
pay their bills.

 Yet, over the past 40 years, both countries, along

with a number of other nations, have
experienced uncomfortable episodes of inflation.

 In the United States, the inflation rate peaked at

13% at the beginning of the 1980s. In Britain,
the inflation rate reached 26% in 1975.
Moderate Inflation and Disinflation

 In the short run, policies that produce a booming

economy also tend to lead to higher inflation,
and policies that reduce inflation tend to depress
the economy.

 This creates both temptations and dilemmas for

governments.
 Long-Run Macroeconomic Equilibrium
Aggregate
price level
L R AS

S R AS

P Long-run
E E
LR macroeconomic
equilibrium

AD

Y Real GDP
P
Potential output
 The Output Gap and the Unemployment Rate

 When actual aggregate output is equal to

potential output, the actual unemployment rate
is equal to the natural rate of unemployment.

 When the output gap is positive (an inflationary

gap), the actual unemployment rate is below the
natural rate.

 When the output gap is negative (a recessionary

gap), the actual unemployment rate is above the
natural rate.
An Inflationary Gap: Unemployment will be lower
than the natural rate

Potential
output Inflationary gap
A Recessionary Gap – Unemployment will be higher
than the natural rate

Recessionary gap

Potential
output
Cyclical Unemployment and the Output Gap
Cyclical Unemployment and the Output Gap
Unemployment and Inflation, 1955–1968
Okun’s Law
 A formal description of the relationship between
Unemployment and the Output Gap
 “The Unemployment Rate tends to change at
about half the rate of change in the Output Gap”

Meaning, if the Output Gap grows 4%,

Unemployment will rise 2%

 The is convenient, because it’s easier to measure

unemployment than potential output
Okun’s Law and the Philips Curve
 We know from AD-AS that when there is a
Recessionary gap, prices fall
 Inflation will be negative
 When there is an inflationary gap, prices rise
 Inflation will be positive

 So, lower unemployment rate means higher

inflation rate, and vice versa
 The Short-Run Phillips Curve
Inflation rate

When the unemployment

rate is low, inflation is
high.

When the unemployment

rate is high, inflation is low.

Unemployment rate
The Short-Run Phillips Curve isn’t stable!
Inflation
rate

0
Unemployment
rate

SRPC
0
These are shifts of SRAS!
 This shifts can be caused by expected inflation

 The nonaccelerating inflation rate of

unemployment, or NAIRU, is the
unemployment rate at which inflation does not
change over time.

 The long-run Phillips curve shows the

relationship between unemployment and
inflation after expectations of inflation have had
time to adjust to experience.

 Disinflation is the process of bringing down

inflation that is embedded in expectations.
The NAIRU and the Long-Run Phillips Curve
Inflation
rate

8%
7
6
5
4
3
2
1
E
0 0
3 4 5 6 7 8% Unemployment rate
–1
–2 Nonaccelerating inflation SRPC
rate of unemployment, 0
–3 NAIRU
The NAIRU and the Long-Run Phillips Curve
 4% Unemployment requires accelerating inflation
 More and more inflation, since we are trying to move
upward on a curve that is moving upward

 At 6% Unemployment, inflation won’t accelerate

 At more than 6%, Disinflation would occur

 So, The Long Run Philips Curve is vertical at the

NAIRU. There is no long run tradeoff.
Which of these is a danger if the Fed acts as
though there is a tradeoff between
unemployment and inflation?

A. As people begin to
expect inflation, the
Phillips curve will
shift downwards
B. More and more
deflation will occur
C. Higher levels of
inflation will be
required to get the
same unemployment
D. Eventually, the
Phillips curve will
change slope, sloping
upwards
Suppose the policy makers decide to pursue an
unemployment rate of 2%. This will:

A. cause accelerating
inflation in the long
run.
B. lead to rightward
shifts in the SRPC,
with each shift
reflecting the expected
inflation rate.
C. cause equilibrium
wage rates to fall.
D. Answers (a), (b), and
(c) are correct.
E. Answers (a) and (b)
are correct.
Inflation and Deflation
 A changing price level changes the value of money
 Also changes the value of any nominal debt that
isn’t indexed to the price level
 Nowadays many things are automatically indexed for
inflation, but most things aren’t

 So
 Inflation transfers buying power away from holders of
nominal assets(like cash or bonds)
 Deflation transfers buying power towards holders of
nominal assets
Deflation
 Hurts Borrowers
 They still owe a dollar, but now that dollar represents more
purchasing power

 A huge problem in a recession

 During Great Depression, it takes wealth away from people who
are already cash-poor
 Why spend your cash now, if it will be worth more in the future?
 Spending falls, AD falls

 “Debt Deflation”
 Negative Shock to AD lowers prices, leads to further fall in
spending, shifting AD in more, further fall in prices
 A vicious cycle
The Great Disinflation of the 1980s
The Great Disinflation of the 1980s
Which of these is a danger if the Fed acts as
though there is a tradeoff between
unemployment and inflation?

A. As people begin to
expect inflation, the
Phillips curve will
shift downwards
B. More and more
deflation will occur
C. Higher levels of
inflation will be
required to get the
same unemployment
D. Eventually, the
Phillips curve will
change slope, sloping
upwards
 Inflation Targeting

 Inflation targeting occurs when the central

bank sets an explicit target for the inflation rate
and sets monetary policy to hit that target.

 Taylor Rule says to increase the target interest

rate when inflation goes up, decrease the target
when unemployment goes up
Tracking Monetary Policy
The Fisher Effect
 From way back in Chapter 10

 Real interest Rate = Nominal Interest Rate –

Inflation Rate

 Or

 Nominal rate = Real Rate + Inflation Rate

The Fisher Effect
 Suppose Real Rate = 3%, expected inflation = -1%
 Meaning Deflation

 Then the nominal rate will be 2%

 What if
 Real Rate = 2%
 Inflation is expected to be -3%?

 Nominal Rate = -1%?

 Not Possible!
Low, Low Rates
Zero Lower Bound
 No one will lend at less than 0%
 You’d rather hold on to cash than lose money lending it
out
 So nominal rates cannot go below 0%.

 That means, if there is -3% expected inflation, the

Fed can’t lower the real rate of interest below 3%!

 The Fed’s ability to control the real interest rate is

limited by inflation expectations!
Tracking Monetary Policy

Federal funds rate (Taylor rule)

12%
10%
8%
6%
4%
Federal 2%
funds rate
0%
-2%
-4%
-6%
-8%

Year
Suppose that nominal interest rates are
currently at zero. What will happen if the Fed
increases the money supply?

A. Interest rates will

fall, increasing
investment
B. The public will
simply hold the new
money, without
increasing loans or
spending
C. The money market is
out of equilibrium
D. Nominal interests
will rise despite the
Fed’s action
Zero Lower Bound
 This is a real problem for monetary policy

 If people expect deflation, the Fed loses the ability

to lower interest rates
 Called “The liquidity Trap,” because money generates a
better real return than lending
 If prices are going down, money’s value is going up, so
you’d rather hold money than lend it out

 That’s a real problem if the Fed is trying to

stimulate lending!
The Zero Bound in U.S. History
Japan’s Lost Decade
ECONOMICS
 IS EUROPE TURNING JAPANESE?
 Out of options, the European Central Bank in
June 2014 began charging banks a fee for holding
their money- a negative interest rate.

Source: Eurostat.

C O P Y R I G H T 2 0 1 5 W O R T H P U B L I S H E R S
Zero Lower Bound
 Most of the time, Monetary Policy is the best way
to react to AD and AS shocks
 The Fed can easily change the interest rate to shift AD

 Not so in a liquidity trap!

 The Fed cannot lower the real interest rate any
farther, so they cannot stimulate firms to invest

 This is a time Fiscal Policy is needed

 Direct spending or Tax cuts are needed
 Thus the stimulus
The Zero Bound in U.S. History
Which of these are not a reason to raise
interest rates during a boom?

A. To prevent an
inflationary gap from
developing
B. To keep interest
rates away from the
zero lower bound
C. To prevent a
recessionary gap
from developing
D. To keep
unemployment from
falling below the
NAIRU
 Turning Unconventional

 In 2004, the Federal Reserve began raising the

target federal funds rate. In mid-2007, a sharp
increase in mortgage defaults led to massive losses in
the banking industry and a financial meltdown. At
first the Fed was slow to react; but by September
2007, it began lowering the federal funds rate
aggressively.
 Turning Unconventional

 Why the sharp about-face by the Federal Reserve?

Ben Bernanke, an authority on monetary policy and
the Great Depression, understood the threat of
deflation arising from a severe slump and how it
could lead to a liquidity trap.

 Through repeated interest rate cuts, the Fed

attempted to get back “ahead of the curve” to
stabilize the economy and prevent deflationary
expectations that could lead to a liquidity trap.
 THE 2008 CRISIS AND ITS AFTERMATH
 Severe crisis, slow but steady recovery. Different
story in Europe.

Sources: Bureau of Economic Analysis; Eurostat.

 THE 2008 CRISIS AND ITS AFTERMATH
 By 2011 almost half of all unemployed Americans
were long-term unemployed.

Source: Bureau of Labor Statistics

C O P Y R I G H T 2 0 1 5 W O R T H P U B L I S H E R S
 AFTERSHOCKS IN EUROPE
 The interest rate spread between two countries is
a measure of perceived risk.

Interest spread against (safe) German

10-year bonds

Source: Eurostat

C O P Y R I G H T 2 0 1 5 W O R T H P U B L I S H E R S
 THE STIMULUS–AUSTERITY DEBATE
 Policy makers were divided: did the situation call for:
1. fiscal stimulus (expansionary measures like
government spending or tax cuts to promote
spending and reduce unemployment)?
 Advocates focus on the continued high unemployment and
argue that a quicker return to economic health will naturally
reduce budget deficits.
2. fiscal austerity (contractionary measures like
spending cuts or tax increases to reduce budget
deficits)?
 Advocates point to Greece’s budget woes and worry that more
stimulus will cause similar outcomes in other countries.

C O P Y R I G H T 2 0 1 5 W O R T H P U B L I S H E R S