Ch. 31 Monetary Policy
What are some alternative theories of how people form expectations?
1) Adaptive expectations theory: Hypothesizes that people adapt their inflation expectations to their prior or most recent experience. People predict that the same inflation rate will pursue the following year to come. It predicts that people do not always underestimate inflation. But when the inflation rate accelerates, people do underestimate. Overestimation also happens when the inflation rate falls while people expect it to be as high as before. If expectations adapt, the monetary policy may not have real effects, even in the short run. Expansionary monetary policy can stimulate the economy and reduce unemployment only if it is unexpected. This theory implies that people are not quite as simpleminded as the basic Phillips curve implies. Stagflation is a macroeconomic condition with a combination of high unemployment rates and high inflation rather than the negative relationship (which occurred in the 70s and baffled economists). 2) Rational expectations theory: Holds that people form expectations on the basis of all available information. When rational, they use more than just today's current level of inflation to predict next year's. It is more forward-looking rather than the adaptive past experience. If there is a trend, rational people will expect the trend to continue rather than stick with the inflation they had prior. However people expect, it's important to remember that prediction errors are inevitable. But also, people are unlikely to under-predict consistently, even when inflation is accelerating. Rational expectations theory identifies prediction errors as random.
What are the 3 limitations of monetary policy?
1) Diminished effects of monetary policy in the long run: Some prices takes longer to adjust, in the long run all prices adjust. Output prices adjust relatively quickly. Input prices are often the slowest prices to adjust. Money illusion can make input suppliers reluctant to lower their prices. In the long run, input prices do change. In the long run, as prices adjust throughout the macroeconomy, the stimulating effects of expansionary monetary policy wear off. You might be able to initially pay for your input and output prices, but eventually all prices adjust and you have to lay off workers and decrease GDP in the long run. Even though AD shifts right, the short-run supply eventually shifts left, to long-run equilibrium where GDP and unemployment are the same before the enactment of the monetary policy, but now the price level is much higher than the short-run increase. THE OUTCOMES of long-run productivity are not necessarily determined by the increase in money supply, but by resources, technology, and institutions. The idea that the money supply does not affect real economic variables is known as monetary neutrality. It may look bad for the Fed to enact monetary policy, but the short-run benefits times of depression. 2) Expectations of inflation can dampen the effects of monetary policy: Short-run aggregate supply can shift back when workers and resource suppliers expect higher future prices, because they do not want their real prices to fall. If short-run aggregate supply shifts along with the shift in aggregate demand, the economy can go straight to equilibrium at point C, long-run equilibrium. In this case, monetary policy ends up having no real effect on the economy. The only thing that changes is that price level rise immediately to their highest. So, monetary policy has real effects only when some prices are sticky. If inflation is expected, prices are not sticky. 3) Economic downturns can be caused by shifts in aggregate supply rather than aggregate demand: An economic downturn can cause both aggregate demand and supply to shift left and form a much smaller long-run equilibrium point where real GDP diminishes and the natural unemployment rate rises. Monetary policy will not be able to shift demand and supply back to its original long-run equilibrium, but instead only make inflation rise. Monetary policy works through aggregate demand, the effects of monetary policy can be limited if shifts in aggregate supply cause a recession. The bottom line is that monetary policy does not enable us to avoid or fix every economic downturn.
What is the Phillips curve?
British economist A. W. Phillips noted a short-run negative relationship between inflation and unemployment rates. It clarifies that higher inflation can lead to lower levels of unemployment in the short run. Similarly, lower inflation is associated with higher unemployment rates. Data shows to be quite consistent around Phillips curve. It also implies that a central bank can choose higher or lower unemployment rates simply by adjusting the rate of inflation in an economy. But this is not always true, let's now consider the Long-Run Phillips curve: In the long-run, after the short-run equilibrium point, prices adjust and the unemployment rate returns to its previous unemployment rate no matter what the inflation rate is.
What can increasing the money supply do in the short-run?
It can expand he amount of credit (loanable funds) available and paves the way for economic expansion.
What is active monetary policy?
It involves the strategic use of monetary policy to counteract macroeconomic expansions and contractions. In the past, it was believed that monetary policy should be used to increase inflation during contractions and decrease inflation during expansions. Modern expectations however believe that if people anticipate the strategies of the central bank, the power of the monetary policy erodes. If expectations are adaptive, activist monetary policy provides only temporary short-run gains in employment. In the long run, it produces high inflation or unemployment, or even both. If expectations are formed rationally, then activist monetary policy may yield no gains whatsoever. The central bank is unlikely to achieve positive results from activist monetary policy, even in the short-run.
What is expansionary monetary policy?
It occurs when a central bank acts to increase the money supply in an effort to stimulate the economy. It typically expands the money supply through open market purchases: it buys bonds. This act increases the supply of loanable funds for financial institutions. An increase in the money supply shifts the supply curve in the loanable funds market to the right, which causes interest rate to decrease. The lower interest causes aggregate demand to shift to the right since investment is part of AD (CIGNX) as more firms take loans. This in turn causes the price level to increase as unemployment reduces as well. The price level partial rise does not fully adjust in the short run however. In the short run, output prices are more flexible (they rise in this case) than input prices, which are sticky and do not adjust. In the long run, as prices adjust, the short run effects wear off and then drive down the value of money. The initial new funds help those who get the money first before and prices adjust. There is an increase in real purchasing power for the initial receiver. This is why monetary policy can have immediate real short-run effects. Inflation also takes a while to happen. During the time that prices are increasing, the value of money is constantly moving downward. This monetary policy can hurt those who will experience a price cut, in which your wage is stuck or set in stone before inflation. It also hurts input suppliers that have sticky prices. Lenders are also harmed when inflation becomes greater than anticipated.
What is contractionary monetary policy?
It occurs when a central bank takes action that reduces the money supply in the economy. Mostly when the economy is expanding rapidly and the bank fears inflation. The central bank reduces the money supply through open market operations by selling bonds in the loanable funds market. This in turn takes funds out of the loanable funds market because the banks buy the bonds from the central bank with money they might otherwise lend to private borrowers. In the short run as the central banks sells bonds, the supply of loanable funds shifts to the left. This in turn, causes the interest rate to rise. This higher interest rate leads to a decrease in the quantity of investment demand which leads to a shift decrease in aggregate demand. This in the short term causes real GDP to decline and unemployment to increase, and eventually leads to a lower price level. But this is not yet fully adjusted either. These short-run results are again the result of fixed resource prices for the firm. A lower money supply leads to downward pressure on prices, but sticky resource prices mean that firms cannot adjust their workers' wages or the terms of their loans in the short run. Firms end up reducing output and lay off some workers.
What is passive monetary policy?
Many economists feel that monetary policy surprise actions should be minimized. This type of policy occurs when central banks purposefully choose only to stabilize the money supply and price levels through monetary policy. The Fed has moved markedly in this direction since the early 1980s. Passive policy does not seek to use inflation to affect real variables. The goal is to reduce surprises as well. It believes that the central bank ought to be transparent.
How can we reconsider how different expectations affect the Phillips curve relationship, which works when inflation is a surprise?
There are different short-run Phillips curve (SRPC) for each level oof expectations about inflation. No expected inflation will cause all to occur like the normal Phillips curve. But if inflation is expected then the Phillips curve shifts the equilibrium to the long-run Phillips curve. If it comes out to be the expected value, then no change in the unemployment rate occurs. In reality, data over the long run presents a picture of inflation and unemployment rates that look random. Clearly, the unemployment rate is not always correlated with the inflation rate in the long run.