ECN 506 Chapter 15: Chapter 15-Money and Banking

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4 Aug 2016
Chapter 15: Policies for Economic Stability
Every economy goes through different phases of business cycles in which output and
employment are above or below their long run levels. During an economic expansion phase of
the business cycle, output and employment are above the long-term level. Output and
employment reach a peak at the end of an economic expansion. During a recession, on the other
hand, output and employment decline below the long term level. Output and employment reach a
trough at the end of the recession (see Figure 17.1 in the textbook).
Stabilizing the economy means smoothing out the peaks and troughs in output and employment
around their long-run growth paths. It is a key short run objective for the central banks. Even
though monetary policy can't affect either output or employment in the long run, it can affect
them in the short run. Monetary policy tools are used to affect output, employment, and the
inflation rate over the business cycle.
In most industrialized nations, monetary policy has two basic goals:
(i) to promote maximum sustainable output and employment; and
(ii) to promote stable prices.
Central banks choose the level of the long-run inflation rate that is best for the economy.
Central banks stabilize the economy by dampening fluctuations caused by expenditure
and supply shocks.
Stabilization policy is conducted by adjusting the target short-term interest rate.
Interest rate policy during a financial crisis differs from policy in normal times.
15.1 Choosing the Long-Run Inflation Rate
Shocks change the short-run inflation rate, but the central bank controls the inflation rate
in the long run the average level around which inflation fluctuates.
The Fed has kept the inflation rate low in response to Congress’s “stable price” mandate.
Low inflation also results in “moderate short-term interest rates.”
By the Fisher equation, i = r + πe
Keeping inflation low keeps πe low, thus keeping i low.
Does stable prices mean zero inflation or a low but positive rate?
The Case for Zero Inflation
Inflation hurts the economy because it causes relative price variability and discourages
saving due to its effects on taxes.
Research suggests that lowering inflation from 2% to 0% will result in higher saving and
economic growth.
The permanent increase in output would by 1% of GDP, a substantial benefit.
The Case for Positive Inflation
Cost of Disinflation
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-there are transitional costs of reducing it
If inflation is 2%, reducing it to zero requires tightening monetary policy, causing a
temporary recession reducing output and raising unemployment.
If the distortions caused by 2% inflation are low, the costs of reducing it may
exceed the benefits.
Small amount of inflation is a nuisance, not a major economic problem
Avoiding Liquidity Traps
-nominal interest rates hits its lower bound of zero, the central bank reduces its usual ability to
stimulate the economy
-Positive inflation helps avoid liquidity traps since the lower bound for the real interest rate is –π;
so positive inflation reduces this lower bound below zero to stimulate spending.
Fed economists estimated that 2% inflation made a liquidity tap unlikely, but
recent experience casts doubt on this conclusion.
-inflation reduces the risk that a desired policy might be impossible
-Federal funds rate approached zero in December 2008, when the federal funds rate fell into a
liquidity trap during the financial crisis
-experience has led some economists to advocate higher inflation to guard against future
liquidity traps
Current Practice
Many central banks have an explicit inflation target, a rate or range that a central bank
announces as its long-run goal for inflation:
Many countries have adopted targets at or around 2%.
In the U.S. the Fed has an implicit inflation target, an inflation level that policymakers
seek without a formal announcement:
Various statements by Fed officials suggest a target range of 1 to 2%.
15.2 Inflation and Output Stability
Expenditure and supply shocks will cause short-run fluctuations in output and inflation,
moving an economy away from its long-run equilibrium.
The Fed cannot eliminate economic fluctuations, but its job is to dampen fluctuations as
much as possible, keeping output and inflation close to their long-run levels.
Inflation Stability
Inflation’s costs are due to its level (mean value) and its variability (variance).
A steady inflation at 2% causes only minimal distortions.
Inflation variability makes ex post real interest rates variable, increasing risk for
borrowers and lenders and reducing investment and economic growth.
Great risk reduces the level of lending, depressing investment and economic growth.
Unstable inflation increases relative price variability, thus increasing economic
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If it was steady, firms adjust prices periodically to keep up with it, and different prices
tend to stay in line with another
Output Stability
-Congress tells the Fed to seek maximum sustainable output growth and maximum employment
-the Fed’s ability to influence output and employment is limited, although policy does effect
short-run movements in output and employment
-central bans try to minimize the year to year fluctuations of these variables around their long run
Because money is neutral, money does not affect potential output or employment in the
long run.
Central banks have the ability to dampen short-run fluctuations in output and
Potential output is not affected by monetary policy
Monetary policy can stabilize (reduce) fluctuations of output around potential.
Central Banks want to stabilize unemployment as well as
Okun’s Law relates output to unemployment, so stabilizing output stabilizes
Balancing the Goals
At times attaining both goals is compatible.
At times the goals conflict:
Stabilizing output can destabilize inflation.
Stabilizing inflation can destabilize output.
The benefits of stabilizing output and inflation are unclear.
Case Study: How Costly is the Business Cycle?
Stabilization does not reduce the average unemployment rate—it just smoothes it over
Is stabilization beneficial?
Economist Robert Lucas argues that the business cycle is not costly.
Output and consumption fall by only a few percentage points in recessions with
offsetting increases in booms.
Fluctuations of this magnitude do not cause much hardship.
Lucas claims that eliminating business cycles improves welfare the same as a
permanent output increase of 0.05%.
Economists disagree with Lucas:
Aggregate fluctuations are modest, but effects on some individuals are large.
Lucas assumes business cycles are symmetric, that losses in recessions are offset by gains
during booms.
Asymmetry is evident in the recent recession: unemployment increased by 5 percentage
points, but no boom will reduce unemployment from 5% to zero.
The costs of business cycles are difficult to quantify.
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