Chapter 13

1. Chapter 13 Macroeconomic Policy and Aggregate Demand and Supply Analysis

2. Preview • To understand the objectives of macroeconomic policy • To understand the relationship between stabilizing inflation and stabilizing economic activity • To understand the Taylor rule of monetary policy • To examine how policymakers use macroeconomic policy to stabilize inflation and output fluctuations

3. The Objectives of Macroeconomic Policy • Two primary objectives of macroeconomic policy: • Stabilizing economic activity • Stabilizing inflation around a low level

4. Stabilizing Economic Activity • Economic activity is commonly gauged by the unemployment rate because high unemployment: • causes human misery • leaves workers and other resources idle, reducing output • Instead of a zero rate of unemployment, policymakers target the nature rate of unemployment that is consistent with the maximum sustainable level of employment at which there is no tendency for inflation to increase

5. Stabilizing Economic Activity (cont’d) • The natural rate of unemployment includes: • Frictional unemployment—exists when workers and firms need time to make suitable matchups • Structural unemployment—exists as a mismatch between job skill requirements and worker availability • At the natural rate of unemployment, output moves towards potential output, so the output gap (Y-YP) is zero

6. Stabilizing Economic Activity (cont’d) • In practice, identifying the natural rate of unemployment is not straightforward • Currently, most economists believe the natural rate of unemployment is around 5%, but still it is subject to much uncertainty and disagreement

7. Stabilizing Inflation: Price Stability • High inflation is always accompanied by high variability of inflation, so it reduces economic growth • So central banks pursue a policy goal of price stability—low and stable inflation • Monetary policy is to maintain inflation, π, close to an inflation target, πT—a target level that is slightly above zero, so that the inflation gap(π - πT) is minimized

8. Establishing Hierarchical Versus Dual Mandates • A Hierarchical mandate requires stable prices as a condition of pursuing other goals • Adopted by the European Central Bank (through the Masstricht Treaty), the Bank of England, the Bank of Canada, and the Reserve Bank of New Zealand • A dual mandate requires co-equal objectives of price stability and other objectives • The Federal Reserve the dual mandate of “stable prices and maximum sustainable employment”

9. The Relationship Between Stabilizing Inflation and Stabilizing Economic Activity • What is a central bank’s appropriate policy response to an economic shock? • In the case of a demand shock or a temporary supply shock, the central bank can simultaneously pursue stability in both the price level and economic output • In the case of a permanent supply shock, however, policymakers can achieve either stable prices or stable output, but not both—a tradeoff for a central bank with dual mandates

10. Monetary Policy and the Equilibrium Real Interest Rate • At long-run equilibrium, the real interest rate is the equilibrium real interest rate, r*: • It is the rate of interest that maintains the quantity of aggregate output demanded equal to potential output, or (Y-YP)=0 • The inflation rate is consistent with price stability, or π = πT • It is also the long-run real interest rate for the economy

11. FIGURE 13.1 The Monetary Policy Curve and the Equilibrium Real Interest Rate, r*

12. Policy and Practice: The Federal Reserve’s Use of the Equilibrium Real Interest Rate, r* • The Federal Reserve Board of Governors and the Reserve Bank presidents meet in Washington, D.C. every six weeks to formulate a target for policy interest rates • Before each FOMC meeting, the Board staff distributes projections for the equilibrium real interest rate, r*, to FOMC members in a blue-covered document called the Blue Book • Policymakers actively discuss the r* projections during FOMC monetary policy deliberations

13. Response to an Aggregate Demand Shock • Policy responses to a negative demand shock: • No policy response • Results: Aggregate output will remain below potential for some time and inflation will fall • Policy stabilizes output in the short run • Policymakers can autonomously ease monetary policy by cutting the real interest rate, so that the AD curve shifts to the right and output quickly returns to YP • Monetary policy has no effect on the equilibrium real interest rate, which is the long-run level of the real interest rate • In the case of aggregate demand shocks, there is no tradeoff between the pursuit of price stability and economic activity stability • The divine coincidence occurs as there is no conflict between the dual objectives of stabilizing inflation and economic activity

14. FIGURE 13.2 Aggregate Demand Shock: No Policy Response

15. FIGURE 13.3 Aggregate Demand Shock: Policy Stabilizes Output in the Short Run

16. Response to a Permanent Supply Shock • Policy responses to a negative permanent supply shock (reducing YP): • No policy response • Results: The short-run AS curve keeps shifting up, so that both inflation and the real interest rate are higher • Policy stabilizes inflation • Policymakers can autonomously tighten monetary policy by raising the real interest rate, so that the output gap becomes zero, inflation is at πT, and the real interest rate finally falls • The divine coincidence still remains true when there is a permanent supply shock: there is no tradeoff between the dual objectives of stabilizing inflation and economic activity

17. FIGURE 13.4 Permanent Supply Shock: No Policy Response

18. FIGURE 13.5 Permanent Supply Shock: Policy Stabilizes Inflation

19. Response to a Temporary Supply Shock • Policy responses to a negative temporary supply shock (e.g., oil price surges) that shifts the short-run AS curve but not the LRAS curve: • No policy response • Results: The short-run AS curve shifts back to the initial position, so that output returns to their initial levels. • In the long run, there is no tradeoff between the two objectives, and the divine coincidence holds

20. FIGURE 13.6 Response to a Temporary Aggregate Supply Shock: No Policy Response

21. Response to a Temporary Supply Shock (cont’d) • Policy stabilizes inflation in the short run • Policymakers can autonomously tighten monetary policy by raising the real interest rate, which lowers output further below its potential level, but in order to keep inflation at πT, policymakers need to subsequently reverse the autonomous tightening monetary policy • Stabilizing inflation in response to a temporary supply shock has led to a larger deviation of aggregate output from potential, so this action has not stabilized economic activity

22. Response to a Temporary Supply Shock (cont’d) • Policy stabilizes output in the short run • Policymakers can stabilize output rather than inflation in the short run by autonomously easing monetary policy, so that the output gap returns to zero while inflation rises • Stabilizing output in response to a temporary supply shock has led to a rise in inflation, so inflation has not been stabilized

23. FIGURE 13.7 Response to a Temporary Aggregate Supply Shock: Short-Run Inflation Stabilization

24. FIGURE 13.8 Response to a Temporary Aggregate Supply Shock: Short-Run Output Stabilization

25. The Bottom Line: The Relationship Between Stabilizing Inflation and Stabilizing Economic Activity If most shocks to the macro economy are aggregate demand shocks or permanent aggregate supply shocks, then policy that stabilizes inflation will also stabilize economic activity, even in the short run. If temporary supply shocks are more common, then a central bank must choose between the two stabilization objectives in the short run. In the long run, however, there is no conflict between stabilizing inflation and economic activity in response to temporary supply shocks.

26. How Actively Should Policy Makers Try to Stabilize Economic Activity? • Nonactivists believe that government action is unnecessary to stabilize economic activity because wages and prices are very flexible and so the self-correcting mechanism quickly returns the economy to full employment. • Activists, particularly Keynesians, argue that the government should pursue active policy to eliminate high unemployment because wages and prices are sticky, and so it takes a long time for the self-correcting mechanism to reach the long run.

27. Lags and Policy Implementation • Lags occur in activist policies that shift the AD curve: • Data lag • Recognition lag • Legislative lag • Implementation lag • Effectiveness lag

28. Policy and Practice: The Activist/Nonactivist Debate Over the Obama Fiscal Stimulus Package • When President Obama entered office in January 2009, he faced a very serious recession with unemployment over 7% and rising • Many activists argued that the Fed should aggressively pursue monetary policy in addition to a massive fiscal stimulus package • On the other hand, nonactivists opposed the fiscal stimulus because of its long implementation lags, which would lead to increased volatility in inflation and economic activity

29. The Taylor Rule • The Taylor rule guides the Federal Reserve to set the real federal funds rate, r, at its historical average of 2%, plus a weighted average of the inflation gap and the output gap: • r = 2.0 + 2(π - πT) + 2 (Y - YP) • In terms of the (nominal) federal funds rate: • Federal funds rate = π + 2.0 + 2 (π - πT) +2 (Y - YP)

30. The Taylor Rule Versus the Monetary Policy Curve • As for the monetary policy curve, the Taylor rule incorporates the inflation gap and output gap: • The Fed should raise the real federal funds rate with an increase in the inflation gap, and vice versa • The Fed should raise the real federal funds rate with an increase in the output gap, and vice versa

31. The Taylor Rule Versus the Monetary Policy Curve (cont’d) • In the case of aggregate demand shocks, the Taylor rule suggests a positive relationship between the real federal funds rate and the output gap (shifting the MP curve) • In the case of a temporary aggregate supply shock, the Taylor rule requires the Fed to focus on economic activity in addition to inflation

32. The Taylor Rule in Practice • The Taylor rule describes the Fed’s control of the federal funds rate under its two most recent chairmen, Alan Greenspan and Ben Bernanke • Evidence shows that the Fed does not follow the Taylor rule exactly as this rule does not explain all the movements in the federal funds rate

33. FIGURE 13.9 The Taylor Rule and the Federal Funds Rate, 1960-2010

34. Policy and Practice: The Fed’s Use Of The Taylor Rule • If the Taylor rule is useful as a policy guide, then why hasn’t the Fed putting monetary policy on autopilot with a Taylor rule with fixed coefficients? • The economy changes all the time, so the Taylor rule coefficients are unlikely to stay constant over time • Economists do not know the current inflation and output gap with certainty • Because of lags, monetary policy conduct is a forward-looking activity the requires the Fed to forecast inflation and economic activity in the future

35. Inflation: Always and Everywhere a Monetary Phenomenon • Our aggregate demand and supply analysis supports Milton Friedman’s adage that in the long run, “Inflation is always and everywhere a monetary phenomenon” • Suppose the central bank chooses to raise the its inflation target, the results are: • The monetary authorities can target any inflation rate in the long run with autonomous monetary policy adjustments • Although monetary policy controls inflation in the long run, it does not determine the equilibrium real interest rate • Potential output—and therefore the quantity of aggregate output produced in the long run—is independent of monetary policy • The classical dichotomy and monetary neutrality (Ch.5) hold

36. FIGURE 13.10 A Rise in the Inflation Target

37. High Employment Targets and Inflation Causes of Inflationary Monetary Policy • The primary goal of most governments (including that of the U.S.) is high employment but the pursuit of this goal can bring high inflation • Activist stabilization policy to promote high employment can result in two types of inflation: • Cost-push inflation—results either from a temporary negative supply shock or wage hikes beyond what productivity gains can justify • Demand-pull inflation—results from policymakers pursuing policies that increase aggregate demand

38. Cost-Push Inflation • Suppose a temporary negative supply (cost push) shock occurs, so that the short-run AS curve shifts up and the left, then: • Initially output will to a level below its potential, inflation will rise and unemployment will rise • In response to an increase in the unemployment rate, activist policymakers with a high employment target would implement expansionary policies to shift the AD curve to the right • However, unemployment will rise again because the short-run AS curve will shift up and to the left as workers seek higher wages to keep their real wages from falling (due to higher inflation) • This process continues and continuing inflation occurs

39. FIGURE 13.11 Cost-Push Inflation

40. Demand-Pull Inflation • Suppose policymakers set an unemployment target (4%) that is below the natural rate of unemployment (5%), resulting in expansionary fiscal policy or an autonomous easing of monetary policy that shifts the AD curve upward, then: • Policymakers would initially achieve the 4% unemployment rate target so that output is at its target YT • However, wages would subsequently increase, shifting the short-run AS curve up and to the left, resulting in a steadily rising inflation rate

41. FIGURE 13.12 Demand-Pull Inflation

42. Application: The Great Inflation • In 1965-1973, the U.S. economy experienced demand-pull inflation as a result of autonomous monetary policy easing that shifted the AD curve to the right as policymakers tried to achieve a low unemployment target of 4% • Most economists today agree that the natural rate of unemployment was instead 5% or 6%, so that the 5% unemployment target initiated the inflationary episode • After 1975, high expected inflation resulted from the demand-pull inflation shifted the short-run AS curve upward and to the left, causing rising unemployment that policymakers tried to reduce by autonomous monetary policy easing • The process of shifting both short-run AS and AD curves resulted in a continuing rise in inflation

43. FIGURE 13.13 Inflation and Unemployment, 1965-1982

44. FIGURE 13.13 Inflation and Unemployment, 1965-1982 (cont’d)