Chapter 14 Inflation and Monetary Policy
Review Questions
2. If the Fed increases the interest rate target, the price of bonds drops. Bonds become more attractive, so people sell stocks to acquire bonds, and stock prices drop as well. Conversely, if the Fed lowers the interest rate target, the price of bonds and stocks increases. An expected change in the Fed’s interest-rate target will also cause movements in stock and bond prices. For example, if people expect the Fed to raise its interest rate target in the near future, they also expect stock and bond prices to fall in the near future. People will want to sell their bonds and stocks now, before the target is raised, so the prices of bonds and stocks will drop in the present.
4. A negative supply shock sends prices up and unemployment up as well. The Fed faces a tradeoff because shifting the AD curve rightward would lessen the rise in unemployment, but increase prices further. Shifting the AD curve leftward would lessen the rise in prices, but increase unemployment further. A hawk policy moves the AD curve leftward because it is tougher on inflation, while a dove policy moves the AD curve to the right, in order to lessen the rise in unemployment.
6. The Phillips curve describes the relationship between inflation and unemployment in the short run. By adjusting the rate at which the AD curve shifts, the Fed moves along the Phillips curve in the short run. The long-run Phillips curve is vertical since in the long run the unemployment rate returns to its natural rate; monetary policy only determines the price level.
8. The uncertain and changing time lags before monetary policy affects the economy, and lack of knowledge of the economy’s potential output are two of the most important information problems faced by the Fed.
10. First, it made announcements designed to reassure the public by pointing out that a modest deflation rate was unlikely to create a downward spiral for the economy, and that if the deflation was perceived to be temporary, it would not affect the economy significantly.
Second, it announced that it was prepared to change the way it conducts monetary policy should the need arise. By buying long term government bonds, the Fed could still reduce other interest rates in the economy.
Finally, the Fed could lower the real interest rate by raising expected inflation, if the need arose. (It could do this by announcing believable policies designed to raise the inflation to a modest, positive level.)
Problems and Exercises
2.
The tax hike is a negative spending shock, which would shift the AD curve to the left. With passive monetary policy, the Fed would leave the money supply unchanged. The economy would slide down the AS curve to point F. Both output and the price level would fall (and the money demand curve would shift to the left, moving money market equilibrium to point B). If the Fed decides to use active policy to neutralize the spending shock, it must increase the money supply. This action would lead to a lower interest rate (at point C), which would stimulate consumption and investment spending by enough to offset the initial spending shock. The economy would return to point E.
4. Possibly, the announcement itself would be enough to change the behavior of workers and firms. Understanding that the new Chair would fight unemployment even at the cost of inflation, they would expect higher inflation in the future. People would build higher inflation into their contracts and the Phillips curve would shift upwards. At each level of unemployment, there would be a higher inflation rate. If the announcement were not enough to change expectations, but the Chair did, in fact, turn out to be more concerned with unemployment than inflation, the aggregate demand curve would begin shifting rightward more rapidly. The economy would ride up the Phillips curve in the short run, and once a higher inflation rate were built in to contracts, the Phillips curve would shift upward.
6.
The Fed would have to increase the money supply increasingly more rapidly in each successive year. This year, for example, it could increase the money supply by enough to choose the unemployment rate-inflation rate combination of U2 and 9%. But, as the short run Phillips curve shifts rightward to PCbuilt-in inflation = 9%, the Fed would have to increase the money supply even more next year, in order to move the economy to point K. But this, in turn, would make the short run Phillips curve shift rightward again. The inflation rate would rise continuously.
8. The problem is that ongoing, expected deflation creates difficulties for monetary policy. The Fed can lower its Federal Funds rate target all the way to 0%--but it can't use open market operations or any of its other tools to make the Federal Funds rate fall below 0%.
Think about what would happen if the Federal Funds rate fell to 0%. If this happened, the Fed would not be able to use open market operations to reduce interest rates further. This could limit the Fed’s ability to raise aggregate expenditure and output with monetary policy.
Challenge Questions
2.
Assume the economy is initially in equilibrium at point E. If the Fed wrongly believes that the natural rate of unemployment is higher and acts to bring the economy back to its supposed potential, it will decrease the money supply. This will cause the interest rate to rise from r1 to r2, causing the AD curve to shift leftward from AD1 to AD2. The economy will experience a lower price level and higher unemployment (at point F). With no more intervention, wage rates will eventually fall, causing the AS curve to shift rightward from AS1 to AS2, returning the economy to full employment (at point G). If the Fed, however, continues to decrease the money supply in an effort to maintain output below potential, the public will come to expect deflation in the future, and the economy will experience ongoing deflation.
4. No. As people see the Fed increasing the money supply more rapidly in each successive year, their expectations of future inflation rates would change and the short run Phillips curve would shift rightward by increasingly larger amounts in successive years. This would make it even harder for the Fed to keep the unemployment rate below the natural rate.
Economic Applications Exercises
2. a. These diagrams confirm Fed’s implementation of expansionary monetary policy during recessions and contractionary monetary policy to fight inflation.
b. Bernanke does not argue for strict rules, but for what he calls constrained discretion. Constrained discretion is defined by two principles. First, through its words and (especially) its actions, the central bank must establish a strong commitment to keeping inflation low and stable. Second, subject to the condition that inflation be kept low and stable, and to the extent possible given our uncertainties about the structure of the economy and the effects of policy, monetary policy should strive to limit cyclical swings in resource utilization. In short, under constrained discretion, the central bank is free to do its best to stabilize output and employment in the face of short-run disturbances, with the appropriate caution born of our imperfect knowledge of the economy and of the effects of policy. However, a critical proviso is that, in conducting stabilization policy, the central bank must also maintain a strong commitment to keeping inflation—and, hence, public expectations of inflation—firmly under control. Because monetary policy influences inflation with a lag, keeping inflation under control may sometimes require the central bank to anticipate and move in advance of inflationary developments--that is, to engage in “preemptive strikes” on inflation. In Bernanke’s view, constrained discretion characterizes the current monetary policy framework of the United States.