The Economics of Money, Banking, and

Financial Markets
Thirteenth Edition
Global Edition

Chapter 24
Monetary Policy Theory

Copyright © 2022, 2019, 2016 Pearson Education, Ltd. All Rights Reserved
Preview
• This chapter uses the aggregate demand-aggregate
supply framework developed in the preceding chapter to
develop a theory of monetary policy.

Copyright © 2022, 2019, 2016 Pearson Education, Ltd. All Rights Reserved
Learning Objectives (1 of 2)
24.1 Illustrate and explain the policy choices that monetary
policy makers face under the conditions of aggregate
demand shocks, temporary supply shocks, and permanent
supply shocks.
24.2 Identify the lags in the policy process and summarize
why they weaken the case for an activist policy approach.
24.3 Explain why monetary policy makers can target any
inflation rate in the long run but cannot target aggregate
output in the long run.

Copyright © 2022, 2019, 2016 Pearson Education, Ltd. All Rights Reserved
Learning Objectives (2 of 2)
24.4 Identify the sources of inflation and the role of
monetary policy in propagating inflation.
24.5 Explain the unique challenges that monetary policy
makers face at the zero lower bound, and illustrate how
nonconventional monetary policy can be effective under
such conditions.

Copyright © 2022, 2019, 2016 Pearson Education, Ltd. All Rights Reserved
Response of Monetary Policy to Shocks
• Monetary policy should try to minimize the inflation gap,
i.e. the difference between inflation and the inflation
target.
• In the case of both demand shocks and permanent
supply shocks, policy makers can simultaneously pursue
price stability and stability in economic activity.
• Following a temporary supply shock, however, policy
makers can achieve either price stability or economic
activity stability, but not both. This tradeoff poses a
dilemma for central banks with dual mandates.

Copyright © 2022, 2019, 2016 Pearson Education, Ltd. All Rights Reserved
Response to an Aggregate Demand
Shock
• Policy makers can respond to this shock in two possible
ways:
– No policy response
– Policy stabilizes economic activity and inflation in the
short run
• In the case of aggregate demand shocks, there is no
tradeoff between the pursuit of price stability and
economic activity stability. A result Olivier Blanchard
labeled the ‘divine coincidence’

Copyright © 2022, 2019, 2016 Pearson Education, Ltd. All Rights Reserved
Figure 1 Aggregate Demand Shock: No
Policy Response

Copyright © 2022, 2019, 2016 Pearson Education, Ltd. All Rights Reserved
Figure 2 Aggregate Demand Shock: Policy
Stabilizes Output and Inflation in the Short Run

Copyright © 2022, 2019, 2016 Pearson Education, Ltd. All Rights Reserved
Response to a Short Run Supply Shock
• When a supply shock is temporary, policy makers face a
short-run tradeoff between stabilizing inflation and
economic activity.
• Policy makers can respond to the temporary supply
shock in three possible ways:
– No policy response
– Policy stabilizes inflation in the short run
– Policy stabilizes economic activity in the short run

Copyright © 2022, 2019, 2016 Pearson Education, Ltd. All Rights Reserved
Figure 5 Response to a Supply Shock:
No Policy Response

Copyright © 2022, 2019, 2016 Pearson Education, Ltd. All Rights Reserved
Figure 6 Response to a Supply Shock:
Short-Run Inflation Stabilization

Copyright © 2022, 2019, 2016 Pearson Education, Ltd. All Rights Reserved
Figure 7 Response to a Supply Shock:
Short-Run Output Stabilization

Copyright © 2022, 2019, 2016 Pearson Education, Ltd. All Rights Reserved
The Bottom Line: The Relationship Between Stabilizing
Inflation and Stabilizing Economic Activity

• We can draw the following conclusions from this analysis:

1. If most shocks to the economy are aggregate demand shocks,

then policy that stabilizes inflation will also stabilize economic
activity, even in the short run
2. If supply shocks are the most common type, then a central
bank must choose between the two stabilization objectives in
the short run

Copyright © 2022, 2019, 2016 Pearson Education, Ltd. All Rights Reserved
How Actively Should Policy Makers Try to
Stabilize Economic Activity?
• All economists have similar policy goals (to promote high
employment and price stability), yet they often disagree
on the best approach to achieve those goals.
• Nonactivists believe government action is unnecessary
to eliminate unemployment.
• Activists see the need for the government to pursue
active policy to eliminate high unemployment when it
develops.

Copyright © 2022, 2019, 2016 Pearson Education, Ltd. All Rights Reserved
Lags and Policy Implementation (1 of 2)
• Several types of lags prevent policy makers from shifting
the aggregate demand curve instantaneously:
– Data lag: the time it takes for policy makers to obtain
data indicating what is happening in the economy
– Recognition lag: the time it takes for policy makers
to be sure of what the data are signaling about the
future course of the economy

Copyright © 2022, 2019, 2016 Pearson Education, Ltd. All Rights Reserved
Lags and Policy Implementation (2 of 2)
• Several types of lags prevent policy makers from shifting
the aggregate demand curve instantaneously:
– Legislative lag: the time it takes to pass legislation to
implement a particular policy
– Implementation lag: the time it takes for policy
makers to change policy instruments once they have
decided on the new policy
– Effectiveness lag: the time it takes for the policy
actually to have an impact on the economy

Copyright © 2022, 2019, 2016 Pearson Education, Ltd. All Rights Reserved
FYI: The Activist/Nonactivist Debate Over the
Obama Fiscal Stimulus Package

• Many activists argued that the government needed to do

more by implementing a massive fiscal stimulus package.
• On the other hand, nonactivists opposed the fiscal
stimulus package, arguing that fiscal stimulus would take
too long to work because of long implementation lags.
• The Obama administration came down squarely on the
side of the activists and proposed the American Recovery
and Reinvestment Act of 2009, a $787 billion fiscal
stimulus package that Congress passed on February 13,
2009.

Copyright © 2022, 2019, 2016 Pearson Education, Ltd. All Rights Reserved
Inflation: Always and Everywhere a
Monetary Phenomenon
• This adage is supported by our aggregate demand and
supply analysis because it shows that monetary policy
makers can target any inflation rate in the long run by
shifting the aggregate demand curve with autonomous
monetary policy.

Copyright © 2022, 2019, 2016 Pearson Education, Ltd. All Rights Reserved
Figure 8 A Rise in the Inflation Target

Copyright © 2022, 2019, 2016 Pearson Education, Ltd. All Rights Reserved
Causes of Inflationary Monetary Policy
• High employment targets and inflation:
– Cost-push inflation results either from a temporary
negative supply shock or a push by workers for wage
hikes beyond what productivity gains can justify.
– Demand-pull inflation results from policy makers
pursuing policies that increase aggregate demand.

Copyright © 2022, 2019, 2016 Pearson Education, Ltd. All Rights Reserved
Figure 9 Cost-Push Inflation

Copyright © 2022, 2019, 2016 Pearson Education, Ltd. All Rights Reserved
Figure 10 Demand-Pull Inflation

Copyright © 2022, 2019, 2016 Pearson Education, Ltd. All Rights Reserved
Application: The Great Inflation
• Now that we have examined the roots of inflationary monetary
policy, we can investigate the causes of the rise in U.S.
inflation from 1965 to 1982, a period dubbed the “Great
Inflation.”
• Panel (a) of Figure 11 documents the rise in inflation during
those years. Just before the Great Inflation started, the
inflation rate was below 2% at an annual rate; by the late
1970s, it averaged around 8% and peaked at nearly 14% in
1980 after the oil price shock in 1979.
• Panel (b) of Figure 11 compares the actual unemployment
rate to estimates of the natural rate of unemployment.

Copyright © 2022, 2019, 2016 Pearson Education, Ltd. All Rights Reserved
Figure 11 Inflation and Unemployment, 19
65–1982

Copyright © 2022, 2019, 2016 Pearson Education, Ltd. All Rights Reserved
Monetary Policy at the Zero Lower Bound
• The Fed can attempt to reduce the real interest rate by
lowering the federal funds rate.
• The federal funds rate, though, is stated in nominal
terms, and therefore cannot fall below zero.
• The zero floor on the federal funds rate is referred to as
the zero lower bound.

Copyright © 2022, 2019, 2016 Pearson Education, Ltd. All Rights Reserved
Deriving the Aggregate Demand Curve
with the Zero Lower Bound
• The MP curve is normally upward sloping.
• With the federal funds rate at the floor of zero, as inflation
and expected inflation fall, the real interest rate rises,
creating a downward slope for the MP curve.
• The process described above creates a kink in the
Aggregate Demand curve as well.

Copyright © 2022, 2019, 2016 Pearson Education, Ltd. All Rights Reserved
Figure 12 Derivation of the Aggregate Demand
Curve With an Effective Lower Bound

Copyright © 2022, 2019, 2016 Pearson Education, Ltd. All Rights Reserved
The Disappearance of the Self-Correcting
Mechanism at the Zero Lower Bound

• When the economy is in a situation in which equilibrium

output is below potential output and the zero lower bound
on the policy rate has been reached, output is not
restored to its potential level if policy makers do nothing.
• In addition, in this situation, the economy goes into a
deflationary spiral, characterized by continually falling
inflation and output.

Copyright © 2022, 2019, 2016 Pearson Education, Ltd. All Rights Reserved
Figure 13 The Absence of the Self-Correcting
Mechanism at the Effective Lower Bound

Copyright © 2022, 2019, 2016 Pearson Education, Ltd. All Rights Reserved
Application: Nonconventional Monetary
Policy and Quantitative Easing (1 of 2)
• Sometimes the negative aggregate demand shock is so
large that at some point the central bank cannot lower the
real interest rate further because the nominal interest rate
hits a floor of zero, as occurred after the Lehman
Brothers bankruptcy in late 2008.
• In this situation when the zero-lower-bound problem
arises, the central bank must turn to nonconventional
monetary policy.

Copyright © 2022, 2019, 2016 Pearson Education, Ltd. All Rights Reserved
Application: Nonconventional Monetary
Policy and Quantitative Easing (2 of 2)
• Nonconventional monetary policy takes three forms:

1. Liquidity provision
2. Asset purchases (quantitative easing)
3. Management of expectations

Copyright © 2022, 2019, 2016 Pearson Education, Ltd. All Rights Reserved
Figure 14 Response to Nonconventional
Monetary Policy

Copyright © 2022, 2019, 2016 Pearson Education, Ltd. All Rights Reserved
Liquidity Provision
• A central bank can bring down financial frictions directly
by increasing its lending facilities in order to provide more
liquidity to impaired markets so that they can return to
their normal functions.
• This decline in financial frictions lowers the real interest
rate for investments.

Copyright © 2022, 2019, 2016 Pearson Education, Ltd. All Rights Reserved
Asset Purchases and Quantitative Easing
• The monetary authorities can also lower financial
frictions by lowering credit spreads through the
purchase of private assets
• Though the Fed took action, the negative aggregate
demand shock to the economy from the global financial
crisis was so great that the Fed’s quantitative (credit)
easing was insufficient to overcome it, and the Fed was
unable to shift the aggregate demand curve all the way
back and the economy still suffered a severe recession.

Copyright © 2022, 2019, 2016 Pearson Education, Ltd. All Rights Reserved
Management of Expectations
• Forward guidance in which the central bank commits to
keeping the policy rate low for a long period of time is
another way of lowering long-term interest rates relative
to short-term rates and thereby lowering financial frictions
and the real interest rate for investments.
• This can lead to both rightward shifts in aggregate
demand and by shifting the short-run aggregate supply
curve by raising expectations of inflation.

Copyright © 2022, 2019, 2016 Pearson Education, Ltd. All Rights Reserved
Figure 15 Response to a Rise in Inflation
Expectations

Copyright © 2022, 2019, 2016 Pearson Education, Ltd. All Rights Reserved
Abenomics and the Shift in Japanese
Monetary Policy in 2013
• A major policy shift occurred in Japan with the election of
Prime Minister Shinzo Abe.
• First, the Bank of Japan was pressured to double its
inflation target.
• Second, the central bank engaged in a program of
quantitative easing.
• This two pronged attack would lower real interest rates
while raising inflationary expectations.

Copyright © 2022, 2019, 2016 Pearson Education, Ltd. All Rights Reserved
Figure 16 Response to the Shift in
Japanese Monetary Policy in 2013

Copyright © 2022, 2019, 2016 Pearson Education, Ltd. All Rights Reserved
Copyright

This work is protected by United States copyright laws and is

provided solely for the use of instructors in teaching their
courses and assessing student learning. Dissemination or sale of
any part of this work (including on the World Wide Web) will
destroy the integrity of the work and is not permitted. The work
and materials from it should never be made available to students
except by instructors using the accompanying text in their
classes. All recipients of this work are expected to abide by these
restrictions and to honor the intended pedagogical purposes and
the needs of other instructors who rely on these materials.

Copyright © 2022, 2019, 2016 Pearson Education, Ltd. All Rights Reserved