CHAPTER 16
INFLATION AND MONETARY POLICY
MASTERY GOALS
The objectives of this chapter are to:
1. Describe how the Fed’s objectives have changed over time, and state its current
objectives.
2. Explain why a low rate of in”ation is important.
3. Explain the link between cyclical unemployment and full employment, and explain why
the Fed is concerned about cyclical unemployment.
4. Explain why the Fed does not try to eliminate frictional and structural unemployment.
5. Show how the Fed uses monetary policy to help stabilize real GDP when there are
spending shocks or a shi+ of the money demand curve.
6. Assuming zero in”ation, show how the Fed deals with shi+s in the money demand curve
when it is following an interest rate target.
7. Explain why the Fed must change its interest rate target if it wants to maintain full
employment and price stability a+er a demand shock.
8. Discuss how changes in the interest rate target affect financial markets.
9. Explain which of the Fed’s options for dealing with a negative supply shock is favored by
in”ation hawks and which is favored by in”ation doves.
10. Compare the effect of hawk and dove in”ation policies.
11. Describe how ongoing in”ation arises.
12. Use a short-run Phillips curve to illustrate the Fed’s short-run choices between in”ation
and unemployment.
13. Show how Fed policies can reduce the rate of in”ation in the short run and discuss the
costs of doing so.
14. Describe how Fed intervention to move the economy along the short-run Phillips curve
will eventually cause this curve to shi+.
15. Use a long-run Phillips curve to illustrate the Fed’s long-run choices and describe how
the Fed can use monetary policy to achieve its choice.
16. Explain why the Fed allows ongoing in”ation.
17. Describe the factors that complicate the execution of monetary policy in the real world.
THE CHAPTER IN A NUTSHELL
The Fed’s objectives have changed over the years. The Federal Reserve System’s chief objective
when it was first established was to ensure the stability of the banking system by acting as a
lender of last resort. By the 1950s its goal was to keep interest rates low and stable. The Federal
Reserve Act of 1978 charged the Fed with achieving both a low, stable in”ation rate and full
employment.
If the Fed changes the money supply in response to shi+s in the money demand curve or to
spending shocks, it is practicing monetary policy. The purpose of monetary policy is to achieve
the goal of a stable level of real GDP. This chapter examines the effect of monetary policy, first
under the assumption of zero ongoing in”ation, and then modifying the analysis with the more
realistic assumption of a low in”ation rate.
To deal with shi+s of the money demand curve, the Fed sets an interest rate target, and changes
the money supply as needed to maintain the target. This policy enables the Fed to achieve its
twin goals of a stable price level and full employment simultaneously.
Responding to a spending shock has the unpleasant side e0ect of causing greater interest rate
“uctuations. Responding to a change in money demand, on the other hand, has the pleasant
side e0ect of stabilizing the interest rate.
Changes in money demand shi+ the AD curve, so they are one kind of demand shock. But there
are other demand shocks as well, originating with a shi+ of the AD curve. To maintain full
employment and price stability a+er a demand shock other than a change in money demand
the Fed must change its interest rate target. A positive demand shock requires an increase in
the target; a negative demand shock requires a decrease in the target. The members of the
Open Market Commi?ee think hard before they vote to change the interest rate target, because
when the Fed raises its target, stock and bond prices fall. Frequent changes in the target would
make financial markets less stable. Changes in expectations about the Fed’s future actions can
be as destabilizing as the actions themselves.
In responding to negative supply shocks, the Fed faces a policy dilemma: decreasing the money
supply will prevent in”ation but deepen the recession, while increasing the money supply will
limit the recession but cause more in”ation. In”ation hawks lean more toward controlling
in”ation, while in”ation doves lean more toward limiting unemployment.
The U.S. economy has experienced ongoing in”ation, beginning in the 1960s. This has led the
public to develop expectations that the in”ation rate in the future will be similar to the in”ation
rates of the recent past. These expectations can be represented by yearly upward shi+s in the
AS curve equal to the built-in rate of in”ation. In the short run, the Fed can bring down the rate
of in”ation by reducing the rightward shi+s of the AD curve, but only at the cost of creating a
recession. The desire to avoid a short-run recession is one reason that the Fed tolerates ongoing
in”ation. The Fed also hesitates to reduce ongoing in”ation because the CPI may overstate the
true in”ation rate and because low but stable in”ation may make the labor market work more
smoothly.
Ongoing in”ation changes our analysis of monetary policy: while the Fed still desires full
employment, its other goal is—price stability—is not zero in”ation, but rather a low and stable
in”ation rate. Another difference is that we use the Phillips curve to illustrate the Fed’s policy
choices between the in”ation rate and the unemployment rate in the short run.
In the short run, the Fed can move the economy along the Phillips curve. But this will cause the
Phillips curve to shi+ in the long run, a+er in”ationary expectations adjust to the change in
actual in”ation. The long-run Phillips curve is a vertical line at the natural rate of
unemployment. The Fed can select any point along this line in the long run, by using monetary
policy to speed or slow the rate at which the AD curve shi+s rightward.
The Fed allows ongoing in”ation because our measures of in”ation actually overstate the true
in”ation rate and because low, stable in”ation may help labor markets adjust more easily.
Information problems (regarding uncertain and changing time lags and determining the natural
rate of unemployment), decisions about using rules or discretion to conduct monetary policy,
and de”ation complicate the execution of monetary policy in the real world.
The chapter concludes with a Using the Theory section on how the Fed should react to asset
pricing bubbles including housing prices during the financial crisis of 2008.
DEFINITIONS
In order presented in chapter.
Natural rate of unemployment: The unemployment rate when there is no cyclical
unemployment.
Phillips curve: A curve indicating the Fed’s choices between in”ation and unemployment in
the short-run.
Long-run Phillips curve: A vertical line indicating that in the long run, unemployment must
equal its natural rate, regardless of the rate of in”ation.
Taylor rule: A proposed rule that would require the Fed to change the interest rate by a
specified amount whenever real GDP or in”ation deviates from its pre-announced target.
TEACHING TIPS
1. The last several chapters in the text have been organized for “exibility. For example,
nothing in the remaining chapters depends on the material in this chapter. Moreover,
this chapter presents two models of Fed behavior: one with zero ongoing in”ation and
one with built-in in”ation. In a time crunch, you could discuss just the model with zero
ongoing in”ation and suggest that students read about built-in in”ation in the major
section, “Expectations and Ongoing In”ation” on their own, for general rather than
technical understanding.
2. Although the Fed’s concern is with reducing cyclical unemployment only, the
government does engage in activities that a?empt to reduce frictional and structural
unemployment. Here are three examples:
a. College placement oGces that are at least partially funded by tax dollars at public
institutions provide services to students, which help reduce frictional
unemployment.
b. The Department of Labor, under the Job Training Partnership Act, administers grants
to retrain unemployed workers. This helps to reduce structural unemployment.
c. The Employment Commission in Tarrant County, Texas, operates a computerized
system that matches unemployed workers with jobs. This helps to reduce frictional
and structural unemployment.
3. Government policies can affect the natural unemployment rate. Use the Welfare Reform
Act of 1996 as an example. This legislation instituted lifetime maximum duration of
eligibility for most individuals. Although its implementation may initially increase the
unemployment rate as people move (or are forced) o0 welfare, in the long run it may
decrease frictional unemployment by increasing the cost of being unemployed. This is an
example of an institutional policy that would cause the natural rate of unemployment to
fall over time.
DISCUSSION STARTERS
1. The text describes how the Fed’s decision to maintain its low interest-rate target in the
face of a rightward shi+ of the AD curve in the late 1960s led to an in”ationary
equilibrium. Discuss the short-run and long-run costs and benefit of the Fed’s other two
options: raising its interest-rate target to neutralize the positive demand shocks, or doing
nothing.
2. The specter of de”ation has led to some interesting discussion about new types of Fed
policies to stimulate the economy in the event the federal funds rate ever goes to zero.
For an essay on de”ation, see an essay by Federal Reserve Chair, Ben Bernanke at
h?p://www.clevelandfed.org/about_us/annual_report/2002/pdf/essay.pdf?
wt.cg_n=general;content%20type;page%20type&wt.cg_s=about%20us;annual
%20report;pdf .
3. For information about the controversial Taylor rule, see Charles T. Carlstrom and Timothy
S. Fuerst “The Taylor Rule: A Guidepost for Monetary Policy,” at
h?p://www.clevelandfed.org/research/commentary/2003/0703.pdf .