Lecture 20: Monetary Policy

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Spring Semester ’13-’14 Akila Weerapana

Lecture 20: Monetary Policy

I. OVERVIEW

• In the last lecture we took a more detailed look at fiscal policy under various economic circumstances, such as a recession or a boom. We showed that the appropriate policy was context-dependent, sometimes expansionary policy was called for, sometimes contractionary policy was called for and sometimes doing nothing was the right approach. We also discussed how fiscal policy is affected by lags in implementation that make it hard for policymakers to deliver the desired outcomes with the ease that our model suggests they could.

• In today’s lecture, we will switch focus to examining monetary policy, As before, we will start out assuming that r = ¯ r

^∗

and π = ¯ π

^∗

just to keep things simple. The framework is very similar, except that the Fed will be moving the MP curve rather than the IS curve through its policy responses.

• It’s also a good idea to keep in mind that the monetary policy maker, typically, has a much longer horizon than the fiscal policymaker. In the United States, governments, face elections every 2-6 years, so they are often tempted to implement policy changes that benefit the economy in the short run but have more adverse effects in the long run. On the contrary, the Federal Reserve doesn’t face similar temptations because the Board of Governors of the Fed consists of 7 members appointed by the President to 14 YEAR terms while the chair of the Federal Reserve is appointed to a 4-year term that does not coincide with the President’s term in office to preserve independence.

• Economists also attach great importance to the degree of independence granted to the central bank in a country by the government. The degree of freedom given to the central bank varies widely across countries: but the U.S and the EMU are recognized to have very independent central banks. Economists believe that greater central bank independence leads to better economic performance by allowing the Central Bank to focus on the long run and by disas- sociating the central bank from having to continually worry about the short-term benefits to the economy.

• Now that we have established the long-term perspective and the independence of the Central Bank to a certain degree the next task is to see how the Fed should react to various changes in the economy.

II. GOOD MONETARY POLICY

Monetary Policy in a Recession

• First, let’s focus on what the appropriate monetary policy is to get an economy out of a reces-

sion. The scenarios are very much the same: the key difference is that the Fed is responding by

moving the MP curve whereas the government was moving the IS curve. The diagram below

shows what would happen when, following a spending shock that moves the economy from

IS to IS

^′

(moving the AD to AD

^′

), the Fed responds by choosing a contractionary monetary

policy.

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• A contractionary monetary policy is a decision by the Fed to raise interest rates by more than the current inflation and output gap would require. We can think about contractionary policy in several ways such as a change in the desired interest rate, a change in the targeted rate of inflation, a change in hawkishness, all of which would lead to changes in r even without a change in π or ˆ Y . The most direct way to model it as an increase in the desired real interest rate (¯ r

^∗

↑).

• As the diagram below shows, this does not lead to good outcomes for the economy: the MP curve shifts in to MP

^′

and AD shifts in to AD

^′′

. The result is a deep recession and a prolonged recovery.

Figure 1: Contractionary Monetary Policy when Y < Y

^∗

IS-MP

- 6

@ @

@ @@

@ @

@ @@

Y ˆ

1

Y ˆ

2

0 r

₁

r

0

= r

ⁿ

= ¯ r

^∗

r

_LR

= r

₁ⁿ

r

2

¯ r

^∗₁

r

_t

Y ˆ MP

IS

^′

IS

MP

^′′

MP

^′

. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

? ?

AD-IA

- 6 @

@ @

@@

@ @

@ @@

@ @

@ @@

Y ˆ

1

π

_LR

π

0

= ¯ π

^∗

0 π

_t

Y ˆ IA

^′

IA

AD

^′′

AD

^′

AD

?

Y ˆ

2

• Another possibility is to do nothing: over time, inflation will start to fall and the economy returns to potential output. This is illustrated in the Figure below. In the monetary policy context, it is important to establish that what I mean by ‘doing nothing’ is to say that the Fed is not taking any pre-emptive measures to change interest rates. If inflation and the output gap change, then the Fed will change interest rates: that is already built into the MP curve.

Figure 2: Doing“Nothing” when Y < Y

^∗

IS-MP

- 6

@ @

@ @@

@ @

@ @@

Y ˆ

1

0 r

1

r

0

= r

ⁿ

= ¯ r

^∗

r

LR

= r

₁ⁿ

r

t

Y ˆ MP

IS

^′

IS MP

^′

. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

? ?

?

AD-IA

- 6 @

@ @

@@

@ @

@ @@

Y ˆ

1

π

LR

π

0

= ¯ π

^∗

0 π

t

Y ˆ IA

^′

IA

AD

^′

AD

??

?

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• The third policy is to pursue expansionary monetary policy: The Fed will lower the desired rate of interest preemptively (i.e. before inflation falls) shifting the MP curve and the AD curve out so that the economy does not even suffer a short-term recession and inflation remains stable.

Figure 3: Expansionary Monetary Policy when Y < Y

^∗

IS-MP

- 6

@ @

@ @@

@ @

@ @@

Y ˆ

₁

0 r

1

r

0

= r

ⁿ

= ¯ r

^∗

r

LR

= r

₁ⁿ

= ¯ r

₁^∗

r

t

Y ˆ MP

IS

^′

IS

MP

^′

-

AD-IA

- 6 @

@ @

@@

@ @

@ @@

Y ˆ

₁

π

0

= ¯ π

^∗

0 π

t

Y ˆ IA

AD

^′

AD

-

• Which of these three scenarios would be the best? We can definitely rule out the contractionary policy since it put the economy into a deeper recession. The expansionary policy response is the right default choice in this case, since it delivers the greatest stability.

Monetary Policy When Y = Y

^∗

• Now we consider the possible policy options when Y = Y

^∗

. We keep the assumption that currently inflation is at the target rate and the real interest rate is at the desired rate. As with fiscal policy there are three options for the Central Bank to follow when it comes to monetary policy. We first consider a decision by the Central Bank to follow a contractionary monetary policy. As the figure below shows, this would end up putting the economy into a recession and eventually leaving the economy with a lower inflation rate.

Figure 4: Contractionary Monetary Policy when Y = Y

^∗

IS-MP

- 6

@ @

@ @@

Y ˆ

₁

0 ¯ r

^∗₁

r

1

r

LR

= r

0

= r

ⁿ

= ¯ r

^∗

r

t

Y ˆ MP

IS

MP

^′

. . . . . . . . . . . . . . . . . . . . . . . . .

? ?

AD-IA

- 6 @

@ @

@@

@ @

@ @@

Y ˆ

₁

π

LR

¯ π

^∗

0 π

t

Y ˆ IA

^′

IA

AD

^′

AD

??

?

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• The second policy is to do nothing, in which case the economy will stay where it is. This of course is identical to the do nothing case under fiscal policy when ˆ Y = 0.

Figure 5: Doing Nothing when Y = Y

^∗

IS-MP

- 6

@ @

@ @@

0 r

0

= r

ⁿ

= ¯ r

^∗

r

t

Y ˆ MP

IS

AD-IA

- 6 @

@ @

@@

π

0

= ¯ π

^∗

0 π

t

Y ˆ IA

AD

• The third is an expansionary policy which will shift the MP curve and the AD curve out and lead to a rise in inflation over time.

Figure 6: Expansionary Monetary Policy when Y = Y

^∗

IS-MP

- 6

@ @

@ @@

Y ˆ

1

0 r

_LR

= r

₀

= r

ⁿ

= ¯ r

^∗

r

₁

¯ r

^∗₁

r

t

Y ˆ MP

IS

MP

^′

-

. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

6 6 6

AD-IA

- 6 @

@ @

@@

@ @

@ @@

Y ˆ

1

π

LR

π

0

= ¯ π

^∗

0 π

t

Y ˆ IA IA

^′

AD

^′

AD

^′

66 -

6 • So what is the best policy. Again the obvious answer, as in the fiscal policy case, seems to be to do nothing, if you do nothing, then the economy will remain at potential output and be stable.

• There can be some special cases where it makes sense to follow a contractionary policy: I will explore these subtleties in the next lecture

• What policies WOULD be implemented? Again as long as the Fed is independent and has a

long-term horizon the policy that should be implemented is what would be implemented.

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Monetary Policy in a Boom

• Finally, let’s focus on what the appropriate monetary policy is when ˆ Y > 0. Here we again suppose that some spending increase has moved the economy to a point where ˆ Y > 0.

• The first option we consider is to follow a contractionary policy where the Fed raises the targeted real interest rate to move the economy to potential output. This is illustrated in the Figure below.

Figure 7: Contractionary Monetary Policy when Y > Y

^∗

IS-MP

- 6

@ @

@ @@

@ @

@ @@

Y ˆ

1

0 r

₁

r

₀

= ¯ r

^∗

r

LR

= r

ⁿ₁

= ¯ r

^∗₁

r

_t

Y ˆ MP MP

^′

IS IS

^′

-

AD-IA

- 6 @

@ @

@@

@ @

@ @@

Y ˆ

1

¯ π

^∗

0 π

_t

Y ˆ IA

AD AD

^′

-

• The second possibility is to do nothing: over time, inflation will start to rise as firms start to increase prices since Y > Y

^∗

. Eventually the economy will return to potential output with a higher inflation rate. This is shown in the Figure below.

Figure 8: Doing Nothing when Y > Y

^∗

IS-MP

- 6

@ @

@ @@

@ @

@ @@

Y ˆ

1

0 r

₀

= r

ⁿ

= ¯ r

^∗

r

₁

r

_LR

= r

₁ⁿ

r

_t

Y ˆ MP

IS IS

^′

MP

^′

-

. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

6 6 6

AD-IA

- 6

@ @

@ @@

@ @

@ @@

Y ˆ

1

π

_LR

¯ π

^∗

0 π

_t

Y ˆ IA IA

^′

AD AD - 6 6 6

• The last option is to follow an expansionary policy, this will cause inflation to rise even more

dramatically. This is shown in the last diagram of the lecture for today.Note that I drew the

expansionary monetary policy as pushing the interest rate back down to the original interest

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rate but of course it does not have to be the case, all we know for sure is that the interest rate will get pushed below r

₁

.

Figure 9: Expansionary Monetary Policy when Y > Y

^∗

IS-MP

- 6

@ @

@ @@

@ @

@ @@

Y ˆ

1

0 r

₁

r

2

= r

0

= r

ⁿ

= ¯ r

^∗

r

_LR

= r

₁ⁿ

¯

r

^∗₁

Y ˆ

2

r

t

Y ˆ MP

^′′

IS

^′

MP

IS

MP

^′

. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

6 6

6 - -

. . . . . . . . . . . . . . . . . . . . . . . . . 6

6 AD-IA

- 6 @

@ @

@@

@ @

@ @@

@ @

@ @@

Y ˆ

1

π

LR

π

0

= ¯ π

^∗

0 π

t

Y ˆ IA IA

^′

AD AD

^′

AD

^′′

Y ˆ

2

- - 6

6 6

• Which of these three scenarios would be the best? We can definitely rule out the expansionary policy as being too inflationary. Similarly doing nothing would also lead to more inflation in the economy. The contractionary policy response is the right default choice in this case, since it delivers the greatest stability.

• What would policy be (as opposed to what it SHOULD be)? If the Central Bank is independent and has a long horizon then the central bank is likely to follow the path of policy that is recommended above. In other words policy WOULD be what policy SHOULD be.

IV. COMPLICATIONS AND CAUTIONS

• Based on the above analysis, the task of the Fed in a very simple sense can be defined as

“move the economy to potential output and inflation to the inflation target by changing its desired interest rate to match the natural rate of interest’. In other words, bring about the

’Goldilocks’ outcome, an economy that is not too hot and not too cold, and inflation that is not too low or too high but just right.

• The main problem with the above approach of course is not knowing where Y

^∗

is, which in our case implies not knowing what the value of ˆ Y is with certainty. The Fed has to proceed with caution and try to gauge what the Goldilocks (not too hot, not too cold) level of the economy is.

• This lack of knowledge about where potential output is exactly can explain why the Fed moves in small increments of policy when it typically does. They move rates up or down by 25 basis points over 2-3 meetings instead of making large changes.

• Disgruntlement with the Fed is often rooted in disagreements about potential output. For

example, the extraordinary measures enacted by the Fed have been borne by the belief that

Y < 0 in the U.S. economy today. But what if potential output has also fallen and thus ˆ ˆ Y is

a lot closer to zero than the Fed realizes? Then the Fed should be thinking more about doing

nothing or being contractionary rather than being expansionary.

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• Similar events have cropped up in recent U.S. economic history. In the dot-com boom when spending was high, some people believed that ˆ Y was not very high because Y

^∗

had increased as well so there was little need for the Fed to raise rates. Conversely, some economists think that Fed policy was too loose during the 1970s, which contributed to the high inflation rates seen during the decade. They claimed that the Fed should have realized that both Y and Y

^∗

fell as a result of high oil prices (e.g. high prices driving manufacturing plants out of business by making them uneconomical), and thus ˆ Y had not fallen by much, which should have made it far less likely that the Fed should lower rates).

• What about lags, like we talked about in fiscal policy? Monetary policy does not have an implementation lag similar to what fiscal policy has - the Fed can move instantaneously to adjust the Federal Funds rate through an open market operation as soon as they make a policy decision. What the Fed faces is an impact lag - even though changes in the Fed Funds rate maybe quick, consumer and investor responses are likely to take a long time. After all one does not decide to build a house or buy a tractor or build a factory at the drop of a hat. So it may take 6-9 months for the full impact of a Fed policy decision to be felt in the economy.

So, impact lags will delay the shift of the AD curve in contrast to the clean immediate shifts

we have been drawing.

Lecture 20: Monetary Policy

Spring Semester ’13-’14 Akila Weerapana