Chapter 18: Monetary Policy

Question 1

• 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

Answer 1

Short Run Monetary Policy

Question 2

• A period of time long enough for all prices to adjust
• Indefinite amount of time depending on the scenario
• Reiterate!

Answer 2

Long Run Monetary Policy

Question 3

The price in the loanable funds market is the _________.

Answer 3

Interest Rate

Question 4

When a central bank acts to increase the money supply in an effort to stimulate the economy

Answer 4

Expansionary Monetary Policy:

Question 5

Real vs. Nominal Effects

Answer 5

• 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

Question 6

If inflation is higher than expected, it hurts…

Answer 6

• 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

Question 7

If inflation is lower than expected, it hurts….

Answer 7

• 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

Question 8

When a central bank takes action that reduces the money supply in the economy

Answer 8

Contractionary Monetary Policy

Question 9

The huge decline in the money supply between 1931 and 1933 was a major contributor to the Great Depression

Answer 9

US Money Supply Before and During the Great Depression

Question 10

Shortcomings of Monetary Policy:

Answer 10

(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

Question 11

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)

Answer 11

Monetary Neutrality

Question 12

Monetary policy issues:

Answer 12

• 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

Question 13

Phillips Curve

Answer 13

• In the 1960s British economist A.W. Phillips observed an inverse relationship between unemployment and inflation.

Question 14

Indicates a short-run negative relationship between inflation and unemployment rates.

Answer 14

Phillips Curve

Question 15

Two part policy implication:

Answer 15

Less unemployment < – > higher inflation

Lower inflation < – > higher unemployment

Question 16

US Inflation and Unemployment Rates, 1948-1969

Answer 16

Data from 1948 to 1969 was very consistent with standard Phillips curve predictions: lower unemployment rates were consistently correlated with higher inflation rates

Question 17

Phillips Curve

Answer 17

The Phillips curve does not consider the long-run

Question 18

Long Run Phillips Curve:

Answer 18

• Vertical, rather than downward-sloping

- Over time: Effects of monetary policy wear off and unemployment rate will return to its original level

Question 19

People’s expectations of future inflation are based on their most recent experience.

Answer 19

Adaptive Expectations

Question 20

Adaptive Expectations

Answer 20

• 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

Question 21

The original Phillips curve relationship fell apart in the 1970s when the United States experienced stagnation, the combination of high unemployment and high inflation

Answer 21

US Inflation and Unemployment, 1948-1979

Question 22

People form expectations on the basis of all available information

Answer 22

Rational Expectations Theory

Question 23

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.

Answer 23

Active Monetary Policy

Question 24

Monetary Policy:

Answer 24

• Inflate during downturns

- Reduce inflation during booming economy

Question 25

Implications of Monetary Policy:

Answer 25

• With adaptive expectations: reduce unemployment in the short run
• With rational expectations: potentially no gains

Question 26

When central banks purposely choose only to stabilize money and price levels through monetary policy.

Answer 26

Passive Monetary Policy

Question 27

Implications for Monetary Policy:

Answer 27

(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