Chapter 18: Monetary Policy Flashcards
- Some prices are inflexible and do not adjust
- For example, wages and other resource prices are often set by contract and don’t change immediately
Short Run Monetary Policy
- A period of time long enough for all prices to adjust
- Indefinite amount of time depending on the scenario
- Reiterate!
Long Run Monetary Policy
The price in the loanable funds market is the _________.
Interest Rate
When a central bank acts to increase the money supply in an effort to stimulate the economy
Expansionary Monetary Policy:
Real vs. Nominal Effects
- Monetary policy can have real effects such as increasing output and reducing unemployment
- However, the new money devalues the entire money supply, because prices rise
- As prices adjust over the long run, the effects of the new money wear off
- In the long run, any real effects of monetary policy dissipate completely, and we are left with a problem
- The only change in the long run is a higher price level
If inflation is higher than expected, it hurts…
- Input suppliers that have sticky pieces
- Workers who signed wage contracts
- Resource suppliers who are contracted to sell goods at a given price are hurt by tomorrow’s unexpected inflation
If inflation is lower than expected, it hurts….
- Demanders who signed a fixed price contract
- Employers who create wage contracts
- Resource purchasers who signed long term contracts to buy gods at certain prices
When a central bank takes action that reduces the money supply in the economy
Contractionary Monetary Policy
The huge decline in the money supply between 1931 and 1933 was a major contributor to the Great Depression
US Money Supply Before and During the Great Depression
Shortcomings of Monetary Policy:
(1) Diminished effects in the long run
(2) Effects being reduced by the expectations of rational economic actors
(3) Effectiveness when the downturn is caused by AS, rather than AD
The idea that the money supply does not affect real economic variables
In other words, printing money is not a real factor affecting productivity (until you suffer high inflation or hyper-inflation)
Monetary Neutrality
Monetary policy issues:
- It has only SR effects, so this does not shift LRAS PPC
- Cannot shift LRAS so it has limited ability to return the economy to the original output level
Phillips Curve
- In the 1960s British economist A.W. Phillips observed an inverse relationship between unemployment and inflation.
Indicates a short-run negative relationship between inflation and unemployment rates.
Phillips Curve
Two part policy implication:
Less unemployment < – > higher inflation
Lower inflation < – > higher unemployment
US Inflation and Unemployment Rates, 1948-1969
Data from 1948 to 1969 was very consistent with standard Phillips curve predictions: lower unemployment rates were consistently correlated with higher inflation rates
Phillips Curve
The Phillips curve does not consider the long-run
Long Run Phillips Curve:
- Vertical, rather than downward-sloping
- Over time: Effects of monetary policy wear off and unemployment rate will return to its original level
People’s expectations of future inflation are based on their most recent experience.
Adaptive Expectations
Adaptive Expectations
- In the 1960s, Milton Freidman and Edmund Phelps hypothesized that people adapt their inflation expectations to their prior experience
- If expectations adapt, then monetary policy may not have their proclaimed real effects, even in the short run
- Expansionary monetary policy can stimulate the economy and reduce unemployment only if it is unexpected
The original Phillips curve relationship fell apart in the 1970s when the United States experienced stagnation, the combination of high unemployment and high inflation
US Inflation and Unemployment, 1948-1979
People form expectations on the basis of all available information
Rational Expectations Theory
The strategic use of monetary policy to counteract macroeconomic expansions and contractions. Assumes the Phillips curve relationship between inflation and unemployment holds in the long run.
Active Monetary Policy
Monetary Policy:
- Inflate during downturns
- Reduce inflation during booming economy
Implications of Monetary Policy:
- With adaptive expectations: reduce unemployment in the short run
- With rational expectations: potentially no gains
When central banks purposely choose only to stabilize money and price levels through monetary policy.
Passive Monetary Policy
Implications for Monetary Policy:
(1) Passive Monetary Policy
(2) Does not seek to affect real variables such as unemployment and output
(3) This has been the direction of the Fed since the 1980’s
