Chapter 24
Monetary Policy Theory
Chapter 24 brings a new set of actors into the AD/AS framework—policymakers—and develops
the theory behind monetary policy making, examining how monetary policymakers react to
shocks to the economy in order to stabilize both inflation and economic activity. One unique
feature of the dynamic AD/AS framework in this book is that it can address policy questions that
other frameworks cannot, such as “When does stabilizing inflation, stabilize output (i.e., when
does the divine coincidence occur)?”
Another big issue in macroeconomics is whether policymakers should be activist—i.e., respond
aggressively to fluctuations in economic activity—or alternatively, not respond and be
nonactivist. One way of bringing home to the students the importance of this issue is to discuss
in class the box on the activist/nonactivist debate over the Obama fiscal stimulus package.
The chapter ends with a discussion of monetary policy at the zero lower bound, which is of great
interest currently because the Federal Reserve cannot lower the federal funds rate below the zero
lower bound and so has to resort to nonconventional monetary policy. The dynamic aggregate
demand and supply framework in this text is especially suited to explaining the impact of the
zero lower bound and how nonconventional monetary policy works in this situation. The first
step is to show students how the zero lower bound results in a backward bending aggregate
demand curve, which means that the self-correcting mechanism is no longer operational.
Applying this analysis then allows the instructor to show how nonconventional monetary policy
and quantitative easing works. To show students how relevant this analysis is it can be used to
show how the historic shift in Japanese monetary policy in 2013, which has been dubbed
Abenomics, might help get the Japanese economy out of the funk it has been in for the last
fifteen years.