Monetary

Economics

Ch. 23 Monetary Policy

Triple Crown Accredited

Preview
• To understand the objectives of monetary policy

• To understand the relationship between stabilizing

inflation and stabilizing economic activity

• To examine how policymakers use monetary policy to

stabilize inflation and output fluctuations
 • Two primary objectives of monetary policy:
– Stabilizing economic activity
The Objectives of – Stabilizing inflation around a low level
Monetary Policy
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
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
 • High inflation is always accompanied by high variability
of inflation, so it reduces economic growth

Stabilizing • So central banks pursue a policy goal of price

Inflation: Price stability—low and stable inflation

Stability • 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
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, the central bank can simultaneously

pursue stability in both the price level and economic output

• In the case of a temporary supply shock, however, policymakers can

achieve either stable prices or stable output, but not both—a tradeoff
for a central bank with dual mandates
 • Policy responses to a negative demand shock:
○ No policy response
■ Results: Aggregate output will remain below potential for
some time and inflation will fall
Response to an
○ Policy stabilizes output in the short run
Aggregate ■ Policymakers can autonomously ease monetary policy
Demand Shock by cutting the real interest rate, so that the AD curve
shifts to the right and output quickly returns to YP

■ 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
Aggregate Demand Shock: No Policy Response
AD Shock: Policy Stabilizes Output in the Short Run
 • 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:
Response to a 1- No policy response
Temporary Supply ■ Results: The short-run AS curve shifts back to the
initial position, so that output returns to their initial
Shock levels.
Response to a Temporary Supply Shock:
No Policy Response
 3- Policy stabilizes economic activity in the short run
○ Policymakers can stabilize output rather than
inflation in the short run by autonomously easing
Response to a monetary policy, so that the output gap returns to
zero while inflation rises
Temporary Supply
Shock (cont’d) ○ Stabilizing output in response to a temporary supply
shock has led to a rise in inflation, so inflation has
not been stabilized
Response to a Temporary Supply Shock:
Short-Run Output Stabilization
 2- Policy stabilizes inflation in the short run
○ Policymakers can autonomously tighten monetary
policy by raising the real interest rate, which lowers
Response to a output further below its potential level
Temporary Supply
Shock (cont’d) ○ 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
Response to a Temporary Supply Shock:
Short-Run Inflation Stabilization
 • If most shocks to the macro economy are aggregate
demand shocks, then policy that stabilizes inflation will
The Bottom Line: also stabilize economic activity, even in the short run.
The Relationship
• If temporary supply shocks are more common, then a
Between Stabilizing central bank must choose between the two stabilization
Inflation and objectives in the short run.
Stabilizing Economic
Activity
 Test your understanding
1) When a temporary negative supply shock hits the economy, then in the short-run ________.
A) if the central bank focuses on stabilizing output, it cannot stabilize inflation
B) if the central bank focuses on stabilizing inflation, it cannot stabilize output
C) there will be trade-off between inflation and unemployment
D) all of the above
E) none of the above

2) A negative shock in aggregate demand will likely result in ________.

A) a short run decrease in output
B) a permanently lower equilibrium inflation rate if the central bank does not respond by lowering interest rates
C) an eventual increase in aggregate supply for any inflation rate if the central bank does not respond by lowering
interest rates
D) all of the above
E) none of the above

3) If most shocks to the economy are ________ shocks, then ________.

A) aggregate demand; there is a tradeoff between the dual objectives in the short-run
B) temporary aggregate supply; inflation stabilization policy will not stabilize economic activity in the short-run
C) temporary aggregate supply; output stabilization policy is consistent with no change in inflation in the long-run
D) all of the above
E) none of the above