Sixth Edition

MACROECONOMICS
Global Edition
Olivier Blanchard
International Monetary Fund
Massachusetts Institute of Technology

David R. Johnson
Wilfrid Laurier University

Boston Columbus Indianapolis New York San Francisco Upper Saddle River
Amsterdam Cape Town Dubai London Madrid Milan Munich Paris Montréal Toronto
Delhi Mexico City São Paulo Sydney Hong Kong Seoul Singapore Taipei Tokyo

See, for example, the results
of a survey of managers by
Alan Blinder and Don Choi, in
“A Shred of Evidence on The-

ories of Wage Rigidity,” Quar-
terly Journal of Economics,
1990 105 (4): pp. 1003–1015.
A conflict of metaphors: Be-
cause inflation makes these

real wage adjustments easier
to achieve, some economists
say inflation “greases the
wheels” of the economy. Oth-
ers, emphasizing the adverse
effects of inflation on relative
prices, say that inflation “puts
sand” in the economy.
This reasoning is sometimes

known as the “slippery slope”
argument.
544
Money Illusion Revisited
Paradoxically, the presence of money illusion provides at least one argument for hav-
ing a positive inflation rate.
To see why, consider two situations. In the first, inflation is 4% and your wage goes
up by 1% in nominal terms—in dollars. In the second, inflation is 0% and your wage
goes down by 3% in nominal terms. Both lead to the same 3% decrease in your real
wage, so you should be indifferent. The evidence, however, shows that many people
will accept the real wage cut more easily in the first case than in the second case.
Why is this example relevant to our discussion? As we saw in Chapter 13, the con-
stant process of change that characterizes modern economies means some workers
must sometimes take a real pay cut. Thus, the argument goes, the presence of inflation
allows for these downward real wage adjustments more easily than when there is no
inflation. This argument is plausible. Economists have not established its importance;
but, because so many economies now have very low inflation, we may soon be in a
position to test it.
The Optimal Inflation Rate: The Current Debate
At this stage, most central banks in richer countries have an inflation target of about
2%. They are, however, being challenged on two fronts. Some economists want to
achieve price stability—that is, 0% inflation. Others want, instead, a higher target rate
of inflation, say 4%.
Those who want to aim for 0% make the point that 0% is a very different target rate
from all others: It corresponds to price stability. This is desirable in itself. Knowing the
price level will be roughly the same in 10 or 20 years as it is today simplifies a number
of complicated decisions and eliminates the scope for money illusion. Also, given the
time consistency problem facing central banks (discussed in Chapter 22), credibility
and simplicity of the target inflation rate are important. Some economists and some
central bankers believe price stability—that is, a 0% target—can achieve these goals
better than a target inflation rate of 2%. So far, however, no central bank has actually
adopted a 0% inflation target.
Those who want to aim for a higher rate argue that it is essential not to fall in the
liquidity trap in the future, and that, for these purposes, a higher target rate of infla-
tion, say 4%, would be helpful. Their argument has gained little support among central
bankers. They argue that if central banks increase their target from its current value of
2% to 4%, people may start anticipating that the target will soon become 5%, then 6%,
and so on, and inflation expectations will no longer be anchored. Thus, they see it as
important to keep current target levels.
The debate goes on. For the time being, most central banks appear to be aiming for
low but positive inflation—that is, inflation rates of about 2%.
24-3 The Design of Monetary Policy
Until the early 1990s, the design of monetary policy typically centered around nominal
money growth. Central banks chose a nominal money growth target for the medium
run; and they thought about short-run monetary policy in terms of deviations of nomi-
nal money growth from that target. In the last two decades, however, this design has
evolved. Most central banks have adopted an inflation rate target rather than a nomi-
nal money growth rate target. They think about short-run monetary policy in terms of
movements in the nominal interest rate rather than in terms of movements in the rate
of nominal money growth. The current crisis has shown however some of the limits of
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this approach and raises the question of whether and how monetary policy should be
modified. In this section, we look at the evolution of monetary policy up to the crisis.
We then take up the issues raised by the crisis in the next section.

Money Growth Targets and Target Ranges

Until the 1990s, monetary policy, in the United States and in other advanced countries,
was typically conducted as follows:
■ The central bank chose a target rate for nominal money growth corresponding to
the inflation rate it wanted to achieve in the medium run. If, for example, it wanted
to achieve an inflation rate of 4% and the normal rate of growth of output (the rate
of growth implied by the rate of technological progress and the rate of population
growth) was 3%, the central bank chose a target rate of nominal money growth of 7%.
■ In the short run, the central bank allowed for deviations of nominal money growth
from the target. If, for example, the economy was in a recession, the central bank
increased nominal money growth above the target value, so as to allow for a de-
crease in the interest rate and a faster recovery of output. In an expansion, it might
do the reverse, so as to slow output growth.
■ To communicate to the public both what it wanted to achieve in the medium run
and what it intended to do in the short run, the central bank announced a range
for the rate of nominal money growth it intended to achieve. Sometimes this range
was presented as a commitment from the central bank; sometimes it was pre-
sented simply as a forecast rather than as a commitment.
Over time, central banks became disenchanted with this way of conducting mon-
etary policy. Let’s now see why.

Money Growth and Inflation Revisited

The design of monetary policy around nominal money growth is based on the assump-
tion that there is a close relation between inflation and nominal money growth in the
medium run. Theory tells us that there should be such a relation. The problem is that,  See Chapter 8.
in practice, this relation is not very tight. If nominal money growth is high, inflation will
also be high; and if nominal money growth is low, inflation will be low. But the relation
is not tight enough that, by choosing a rate of nominal money growth, the central bank
can achieve precisely its desired rate of inflation, not even in the medium run.
The relation between inflation and nominal money growth is shown in Figure 24-1,
which plots 10-year averages of the U.S. inflation rate against 10-year averages of the
growth rate of money from 1970 up to the crisis (the way to read the figure: the num- From Chapter 4: M1 measures
bers for inflation and for money growth for 2000 for example are the average inflation the amount of money in the
economy and is constructed
rate and the average growth rate of money from 1991 to 2000). The inflation rate is con- as the sum of currency and
structed using the CPI as the price index. The growth rate of nominal money is con- checkable deposits. The Fed
structed using M1 as the measure for the money stock. The reason for using 10-year  does not directly control M1.
averages should be clear: In the short run, changes in nominal money growth affect What it controls is H, the mon-
mostly output, not inflation. It is only in the medium run that a relation between nomi- etary base; but it can choose
H to achieve the value of M1
nal money growth and inflation should emerge. Taking 10-year averages of both nomi- it wants. It is therefore rea-
nal money growth and inflation is a way of detecting such a medium-run relation. sonable to think of the Fed as
Figure 24-1 shows that, for the United States, the relation between M1 growth and controlling M1.
inflation has not been very tight. True, both went up in the 1970s, and both have come
down since. But note how inflation started declining in the early 1980s, while nominal
money growth remained high for another decade and came down only in the 1990s.
Average inflation from 1981 to 1990 was down to 4%, while average money growth over
the same period was still running at 7.5%.

Chapter 24 Monetary Policy: A Summing Up 545

Figure 24-1
M1 Growth and Inflation:
10-Year Averages, 1970 to
the crisis
There is no tight relation be-
tween M1 growth and inflation,
not even in the medium run.
Source: Series CPIAUSL and M1SL
Federal Reserve Economic Data
(FRED) http://research.stlouisfed.
org/fred2/
From equation (5.3) (the LM
equation): The real money
supply (the left side) must be
equal to the real demand for
money (the right side):
M the real money stock must also decrease by half. For a given nominal money stock, the
= Y L1i2
P
If, as a result of the introduction
of credit cards, the real demand
for money halves, then
M 1
= Y L1i2
P 2
For a given level of output
and a given interest rate, M>P
must also halve. Given M. this
implies P must double.
546
10
8
M1 Growth
Percent per year
6
Inflation
4
0
1970 1975 1980 1985 1990 1995 2000 2005
Why is the relation between M1 growth and inflation not tighter? Because of shifts
in the demand for money. An example will help. Suppose, as the result of the introduc-
tion of credit cards, people decide to hold only half the amount of money they held be-
fore; in other words, the real demand for money decreases by half. In the medium run,

price level must double. Even if the nominal money stock were to remain constant,
there would still be a period of inflation as the price level doubles. During this period,
there would be no tight relation between nominal money growth (which is zero) and
inflation (which would be positive). The Focus box “The Unsuccessful Search for the
Right Monetary Aggregate” explores this further.
Throughout the 1970s and the 1980s, these frequent and large shifts in money de-
mand created serious problems for central banks. They found themselves torn between
trying to keep a stable target for money growth and staying within announced bands (in
order to maintain credibility), or adjusting to shifts in money demand (in order to stabi-
lize output in the short run and inflation in the medium run). Starting in the early 1990s,
a dramatic rethinking of monetary policy took place, based instead on inflation targeting
rather than money growth targeting, and the use of interest rate rules. Let’s look at the
way monetary policy has evolved.
Inflation Targeting
In most countries, central banks have defined as their primary goal the achievement
of a low inflation rate, both in the short run and in the medium run. This is known as
inflation targeting.
■ Trying to achieve a given inflation target in the medium run would seem, and
indeed is, a clear improvement over trying to achieve a nominal money growth
target. After all, in the medium run, the primary goal of monetary policy is to
achieve a given rate of inflation. Better to have an inflation rate as the target than a
nominal money growth target, which, as we have seen, may not lead to the desired
rate of inflation.
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The Unsuccessful Search for the Right Monetary
Aggregate

The reason why the demand for money shifts over time
goes beyond the introduction of credit cards. To under-
stand why, we must challenge an assumption we have
maintained until now, namely that there is a sharp distinc-
tion between money and other assets. In fact, there are
many financial assets that are close to money. They can-
not be used for transactions—at least not without restric-
tions—but they can be exchanged for money at little cost.
In other words, these assets are very liquid; this makes
them attractive substitutes for money. Shifts between
money and these assets are the main factor behind shifts
in the demand for money.
Take, for example, money market fund shares. Money
market funds are financial intermediaries that hold as as-
sets short-maturity securities (typically, Treasury bills) and
have deposits (or shares, as they are called) as liabilities.
The funds pay depositors an interest rate close to the T-bill
rate minus the administrative costs of running the fund.
Deposits can be exchanged for money on notice and at lit-
tle cost. Most money market funds allow depositors to write
checks, but only above a certain amount, typically $500.
Because of this restriction, money market funds are not
included in M 1. When these funds were introduced in the
mid-1970s, people were able for the first time to hold a very
liquid asset while receiving an interest rate close to that
on T-bills. Money market funds quickly became very at-
tractive, increasing from nothing in 1973 to $321 billion in
FOCUS
1989. (For comparison: Checkable deposits were $280 bil-
lion in 1989.) Many people reduced their bank account bal-
ances and moved to money market funds. In other words,
there was a large negative shift in the demand for money.
The presence of such shifts between money and other
liquid assets led central banks to construct and report
measures that include not only money, but also other
liquid assets. These measures are called monetary ag-
gregates and come under the names of M 2, M 3, and so
on. In the United States, M 2—which is also sometimes
called broad money—includes M 1 (currency and check-
able deposits), plus money market mutual fund shares,
money market deposit accounts (the same as money mar-
ket shares, but issued by banks rather than money market
funds), and time deposits (deposits with an explicit matu-
rity of a few months to a few years and with a penalty for
early withdrawal). In 2010, M 2 was $8.6 trillion, compared
to $1.7 trillion for M 1.
The construction of M 2 and other monetary aggre-
gates would appear to offer a solution to our earlier prob-
lem: If most of the shifts in the demand for money are
between M 2 and other assets within M 2, the demand for
M 2 should be more stable than the demand for M 1, and
so there should be a tighter relation between M 2 growth
and inflation than between M1 growth and inflation. If
so, the central bank could choose targets for M 2 growth
rather than for M 1 growth. This is indeed the solution that

10
M2 Growth

8
Percent per year

Inflation
4

0
1970 1975 1980 1985 1990 1995 2000 2005
Figure 1 M2 Growth and Inflation: 10-Year Averages, 1970 to 2007
Source: Series CPIAUSL and M2NS Federal Reserve Economic Data (FRED) http://research.stlouisfed.org/fred2/

Chapter 24 Monetary Policy: A Summing Up 547

 many central banks adopted. But it did not work well, for
two reasons:
■ The relation between M 2 growth and inflation is no
tighter than the relation between M 1 growth and infla-
tion. This is shown in Figure 1, which plots 10-year av-
erages of the inflation rate and of the rate of growth of
M 2 from 1970 to 2007. M 2 growth was nearly 5% above
inflation in the early 1970s. This difference disappeared
over time, only to reappear and grow in the 2000s.
■ More importantly, while the central bank controls
M 1, it does not control M 2. If people shift from T-bills
to money market funds, this will increase M 2—which
includes money market funds but does not include T–
bills. There is little the central bank can do about this
increase in M 2. Thus, M 2 is a strange target: It is nei-
ther under the direct control of the central bank nor
what the central bank ultimately cares about.
In short, the relation between inflation and the growth
of monetary aggregates such as M 2 is no tighter than the
relation between inflation and the growth rate of M 1. And
the central bank has little control over the growth of these
monetary aggregates anyway. This is why, in most coun-
tries, monetary policy has shifted its focus from monetary
aggregates, be it M 1 or M 2, to inflation.

■ Trying to achieve a given inflation target in the short run would appear to be much
more controversial. Focusing exclusively on inflation would seem to eliminate any
role monetary policy could play in reducing output fluctuations. But, in fact, this is
not necessarily the case.
To see why, return to the Phillips curve relation among inflation, pt , lagged in-
flation, pt - 1, and the deviation of the unemployment rate, u t from the natural rate
of unemployment, u n (equation (8.10)):
pt = pt - 1 - a 1u t - u n 2
Let the inflation rate target be p*. Suppose the central bank could achieve its infla-
tion target exactly in every period. Then the relation would become:
p* = p* - a 1ut - un2
The unemployment rate u t would always equal un , the natural rate of unemploy-
0 = - a1ut - un2 1 ut = un. ment; by implication, output would always be equal to the natural level of output.
In effect, inflation targeting would lead the central bank to act in such a way as to
eliminate all deviations of output from its natural level.
The intuition: If the central bank saw that an adverse demand shock was go-
ing to lead to a recession, it would know that, absent a monetary expansion, the
economy would experience a decline in inflation below the target rate of inflation.
To maintain stable inflation, the central bank would then rely on a monetary ex-
pansion to avoid the recession. The converse would apply to a favorable demand
shock: Fearing an increase in inflation above the target rate, the central bank would
rely on a monetary contraction to slow the economy and keep output at the natural
level of output. As a result of this active monetary policy, output would remain at
the natural level of output all the time.
The result we have just derived—that inflation targeting eliminates deviations of
output from its natural level—is too strong, however, for two reasons:
1. The central bank cannot always achieve the rate of inflation it wants in the short
run. So suppose that, for example, the central bank was not able to achieve its de-
sired rate of inflation last year, so pt - 1 is higher than p*. Then it is not clear that the
central bank should try to hit its target this year and achieve pt = p*: The Phillips
curve relation implies that such a decrease in inflation would require a potentially
large increase in unemployment.

548 Back to Policy Back to Policy

2. Like all other macroeconomic relations, the Phillips curve relation above does not
hold exactly. It will happen that, for example, inflation increases even when un-
employment is at the natural rate of unemployment. In this case, the central bank
will face a more difficult choice: whether to keep unemployment at the natural rate
and allow inflation to increase, or to increase unemployment above the natural
rate to keep inflation in check.
These qualifications are important, but the basic point remains: Inflation targeting
makes good sense in the medium run and allows for monetary policy to stabilize out-
put close to its natural level in the short run.

Interest Rate Rules

Given the discussion so far, the question now is how to achieve the inflation target. In-
flation is clearly not under the direct control of the central bank. In answer to this ques-
tion, John Taylor, from Stanford University, argued in the 1990s that, since the central
bank affects spending through the interest rate, the central bank should think directly
in terms of the choice of an interest rate rather than a rate of nominal money growth.
He then suggested a rule that the central bank should follow to set the interest rate.
Recall from Chapter 14 that, in
This rule, which is now known as the Taylor rule, goes as follows: the medium run, the real inter-
est rate is equal to the natu-
■ Let pt be the rate of inflation and p* be the target rate of inflation.
ral real interest rate, rn, so the
■ Let i t be the nominal interest rate controlled by the central bank and i* be the tar- nominal interest rate moves
get nominal interest rate—the nominal interest rate associated with the target rate one-for-one with the inflation
of inflation, p*, in the medium run.  rate: If rn = 2% and the target
■ Let u t be the unemployment rate and u n be the natural unemployment rate. inflation rate p * = 4%, then
the target nominal interest rate
Think of the central bank as choosing the nominal interest rate, i. (Recall, from i* = 2% + 4% = 6%. If the
Chapter 4, that, through open market operations, and ignoring the liquidity trap, the target inflation rate p* is 0%,
then i* = 2% + 0% = 2%.
central bank can achieve any short-term nominal interest rate that it wants.) Then,
Taylor argued, the central bank should use the following rule:
it = i* + a 1pt - p*2 - b 1ut - un2
where a and b are positive coefficients.
Let’s look at what the rule says:
■ If inflation is equal to target inflation 1pt = p*2 and the unemployment rate
is equal to the natural rate of unemployment 1u t = u n2, then the central bank
should set the nominal interest rate, i t , equal to its target value, i*. This way, the
economy can stay on the same path, with inflation equal to the target inflation rate
and unemployment equal to the natural rate of unemployment.
■ If inflation is higher than the target 1pt 7 p*2, the central bank should increase Some economists argue that
the nominal interest rate, i t , above i*. This higher interest rate will increase unem- the increase in U.S. inflation in
ployment, and this increase in unemployment will lead to a decrease in inflation. the 1970s was due to the fact
The coefficient a should therefore reflect how much the central bank cares about that the Fed increased the
nominal interest rate less than
inflation. The higher a, the more the central bank will increase the interest rate in one-for-one with inflation. The
response to inflation, the more the economy will slow down, the more unemploy- result, they argue, was that
ment will increase, and the faster inflation will return to the target inflation rate. an increase in inflation led to
In any case, Taylor pointed out, a should be larger than one. Why? Because what a decrease in the real interest
matters for spending is the real interest rate, not the nominal interest rate. When rate, which led to higher de-
mand, lower unemployment,
inflation increases, the central bank, if it wants to decrease spending and output, more inflation, a further de-
must increase the real interest rate. In other words, it must increase the nominal crease in the real interest rate,
interest rate more than one-for-one with inflation.  and so on.

Chapter 24 Monetary Policy: A Summing Up 549

 ■ If unemployment is higher than the natural rate of unemployment 1u t 7 u n 2, the
central bank should decrease the nominal interest rate. The lower nominal inter-
est rate will increase output, leading to a decrease in unemployment. The coeffi-
cient b should reflect how much the central bank cares about unemployment. The
higher b, the more the central bank will be willing to deviate from target inflation
to keep unemployment close to the natural rate of unemployment.
In stating this rule, Taylor did not argue that it should be followed blindly: Many
other events, such as an exchange rate crisis or the need to change the composition
of spending on goods, and thus the mix between monetary policy and fiscal policy,
justify changing the nominal interest rate for other reasons than those included in the
rule. But, he argued, the rule provided a useful way of thinking about monetary policy:
Once the central bank has chosen a target rate of inflation, it should try to achieve it by
adjusting the nominal interest rate. The rule it should follow should take into account
not only current inflation, but also current unemployment.
Since it was first introduced, the Taylor rule has generated a lot of interest, both
from researchers and from central banks:
■ Interestingly, researchers looking at the behavior of both the Fed in the United
States and the Bundesbank in Germany have found that, although neither of these
two central banks thought of itself as following a Taylor rule, this rule actually de-
scribed their behavior fairly well over the last 15–20 years before the crisis.
■ Other researchers have explored whether it is possible to improve on this simple
rule: for example, whether the nominal interest rate should be allowed to respond
not only to current inflation, but also to expected future inflation.
■ Yet other researchers have discussed whether central banks should adopt an ex-
plicit interest rate rule and follow it closely, or whether they should use the rule
more informally, and feel free to deviate from the rule when appropriate.
■ In general, most central banks have now shifted from thinking in terms of nominal
money growth to thinking in terms of an interest rate rule. Whatever happens to
nominal money growth as a result of following such a nominal interest rate rule is in-
creasingly seen as unimportant, both by the central banks and by financial markets.

24-4 Challenges from the Crisis

Until 2007, most central banks believed that inflation targeting provided them with a
solid framework for monetary policy. In most countries, inflation was stable, and out-
put fluctuations were smaller than they had been in the past. The crisis has presented
them with two challenges:
■ The liquidity trap has prevented them from decreasing the interest rate as much as
they wanted. At the time of this writing, given high unemployment and low inflation,
the nominal interest rate implied by the Taylor rule for the United States should be
around -3%. Yet the actual nominal interest rate cannot go below zero.
■ It has become clear that stable inflation is not, by itself, a guarantee of macroeco-
nomic stability: The crisis can clearly be traced to problems in the housing and the
financial sectors, that built up long before 2007.
Let’s take each challenge from the crisis in turn.

The Liquidity Trap

When an economy falls into the liquidity trap, conventional monetary policy (namely,
the use of the nominal interest rate) can no longer be used. This raises three issues: first,

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