Chapter 24

Monetary Policy Theory

Money and Banking

Deokwoo Nam
Department of Economics and Finance
Hanyang University

Page: 1
1. INTRODUCTION

1 Introduction

In this chapter we develop a theory of monetary policy using the aggregate demand-aggregate supply
(AD/AS) framework developed in the previous chapter.
– Speci…cally, we examine the role of monetary policy in creating in‡ation and stabilizing the economy,
and apply the theory to three big questions:
1. What are the roots of in‡ation?
2. Does stabilizing in‡ation stabilize output?
3. Should policy be activist— by responding aggressively to ‡uctuations in economy activity— or passive
and nonactivist?

Page: 2
2. RESPONSE OF MONETARY POLICY TO SHOCKS

2 Response of Monetary Policy to Shocks

As we saw in Chapter 17, we learned the following objectives of central banks:

1. The central goal of central banks is price sta- 2. Central banks also care about stabilizing eco-
bility. nomic activity.
– It means that they try to maintain in‡ation – Because economic activity can be sustained
close to a target level ( T ). only at potential output, this objective of mon-
T
etary policy can be described as saying that
is referred to as an in‡ation target, that monetary policymakers want to have aggregate
is slightly above zero— most central banks output Y close to its potential output Y P .
set T between 1% to 3%.
– Another way of saying this is that monetary
– Another way of saying this objective is that policy intends to minimize the di¤erence be-
monetary policy should try to minimize the dif- tween aggregate output and potential output,
ference between in‡ation and the in‡ation tar- Y Y P , which we refer to the output gap.
get, T , which we refer to the in‡ation

gap.

In our analysis of aggregate demand supply in Chapter 23, we examined three categories of economic shocks—
demand shocks, temporary supply shocks, and permanent supply shocks— and the consequences of each on
in‡ation and output.
– In this section, we describe central bank’s policy responses to each of these shocks, given its
objectives (stabilizing in‡ation gap, output gap, or both), thereby drawing the following conclusions:
1. In the case of both demand shocks and permanent supply shocks, policymakers can simultane-
ously pursue price stability and stability in economic activity.
2. However, following a temporary supply shock, policymakers can achieve either price stability or
economic activity stability, but not both.
This tradeo¤ poses a thorny dilemma for central banks with dual mandates.
Page: 3
2. RESPONSE OF MONETARY POLICY TO SHOCKS

2.1 Response to an Aggregate Demand Shock

We …rst consider the e¤ects of a negative aggregate demand shock, such as the disruption to …nancial markets
starting in August 2007 that increased …nancial frictions and caused both consumer and business spending to
fall.
– We assume that the economy is initially at point 1 in Figure 1, where output is at Y P (potential output)
and T (in‡ation target).
– The negative demand shock shifts the AD curve leftward from AD1 to AD2 .
Policymakers can respond to this negative demand shock in two possible ways:
1. No Policy Response
– In Figure 1, because the central bank does not for some time, and if in‡ation was initially
respond by changing the autonomous compo- at its target level, the fall in in‡ation is un-
nent of monetary policy, the AD curve remains at desirable for some reasons (outlined in both
AD2 , and thus the economy is at point 2, where Chapters 9 and 17).
output falls to Y2 below Y P and in‡ation falls to
T.
2 below

– With output below potential, slack begins to de-

velop in the labor and product markets, lowering
in‡ation, and thus the SRAS curve will shift down
to AS3 and the economy will move to point 3,
where output is back at Y P while in‡ation fall to
a lower level of 3 .
At …rst glance, this outcome looks favorable
because in‡ation is lower and output is back
at its potential.
But, output will remain below potential
Page: 4
2. RESPONSE OF MONETARY POLICY TO SHOCKS

2. Policy Stabilizes Economic Activity and In‡ation in the Short Run

– The central bank can eliminate "both" the No con‡ict exists between the dual objectives
output gap and the in‡ation gap in the short of stabilizing in‡ation and economic activity,
run by autonomously easing monetary policy of which is referred to as the divine coincidence.
cutting the real interest rate at any given in‡a-
tion.
This action stimulates investment spending
and increases the quantity of aggregate output
demanded at any given in‡ation rate, thereby
shifting the AD curve to the right. As a result,
the AD curve shifts from AD2 back to AD1 in
Figure 2.
The Federal Reserve took exactly these steps
by lowering the federal funds rate from 5% to
1=4% to zero over …fteen months starting in
September 2007.
– In the case of aggregate demand shocks,
there is no tradeo¤ between the pursuit of
price stability and economic activity stability.
A focus on stabilizing in‡ation leads to exactly
the right monetary policy response to stabilize
economic activity.

Page: 5
2. RESPONSE OF MONETARY POLICY TO SHOCKS

2.2 Response to a Permanent Aggregate Supply Shock

We illustrate a permanent negative supply shock, such as when the economy su¤ers because an increase in
regulations permanently reduces the level of potential output.
– We assume again that the economy starts out at point 1 in Figure 3, where output is at Y P (potential
output) and T (in‡ation target).
– The permanent negative supply shock causes potential output to fall and the LRAS curve to shift to the
left. The permanent supply shock triggers a price shock that shifts the SRAS curve upward.
Two policy responses to this permanent supply are possible:
1. No Policy Response
– A permanent negative supply shock decreases po-
tential output from Y1P to Y3P , and the LRAS
curve shifts to the left from LRAS1 to LRAS3 ,
while the SRAS curve shifts upward from AS1
to AS2 . The economy moves to point 2, with
in‡ation rising to 2 and output falling Y2 .
– Because aggregate output Y2 is still above po-
tential output Y3P , the SRAS curve keeps shifting
until the output gap is zero when it reaches AS3 .
The economy will move to point 3, eliminating
the output gap but leaving in‡ation higher at 3
and output lower at Y3P .

Page: 6
2. RESPONSE OF MONETARY POLICY TO SHOCKS

2. Policy Stabilizes In‡ation

– A permanent negative supply shock decreases po-
tential output from Y1P to Y3P , and the LRAS
curve shifts to the left from LRAS1 to LRAS3 ,
while the SRAS curve shifts upward from AS1 to
AS3 .

– An autonomous tightening of monetary policy

(by increasing in the real interest rate at any
given in‡ation rate), which decreases investment
spending and lowers aggregate demand at any
given in‡ation rate, shifts the AD curve to the
left to AD3 , thereby keeping the in‡ation rate at
its target level of T at point 3.
– Here again, keeping the in‡ation gap at zero
leads to a zero output gap, so stabilizing in-
‡ation has stabilized economic activity.
The divine coincidence still remains true when
a permanent supply shock occurs: there is no
tradeo¤ between the dual objectives of stabi-
lizing in‡ation and economic activity.

Page: 7
2. RESPONSE OF MONETARY POLICY TO SHOCKS

2.3 Response to a Temporary Aggregate Supply Shock

We …nally illustrate a temporary negative supply shock, such as when the price oil surges because of political
unrest in the Middle East or a devastating hurricane in Florida because of an act of god.
– In this case, the divine coincidence does not always hold: policymakers face a "short-run" tradeo¤
between stabilizing in‡ation and economic activity.
– We assume that the economy is initially at point 1, where output is at Y P and in‡ation is at T.

– The temporary negative supply shock shifts the SRAS curve upward, but the LRAS curve unchanged.
Policymakers can respond to the temporary supply shock in three possible ways:
1. No Policy Response
– A temporary negative shock shifts the SRAS This opens the door to monetary policy to try
curve upward from AS1 to AS2 , moving the econ- to stabilize economic activity or in‡ation "in
omy at point 2, with in‡ation rising to 2 and the short run."
output falling to Y2 .
– If the autonomous monetary policy remains un-
changed, the SRAS will shift back down and to
the right in the long run, eventually returning to
AS1 , and the economy moves back to point 1.

Both in‡ation and economic activity stabilize

over time. In the long run, there is no
tradeo¤ between the two objectives, and
the divine coincidence holds.
– However, while we wait for the long run, the
economy will undergo a painful period of reduced
output and higher in‡ation rates.

Page: 8
2. RESPONSE OF MONETARY POLICY TO SHOCKS

2. Policy Stabilizes In‡ation in the Short Run

– A second policy choice for monetary authorities Stabilizing in‡ation in response to a tem-
is to keep in‡ation at the target level of T in the porary supply shock has led to a larger de-
short run by autonomously tightening monetary viation of aggregate output from potential
policy, i.e., raising the real interest rate at any (Y3 Y P rather than Y2 Y P in no response
given in‡ation rate. case) so this action has not stabilized eco-
nomic activity.
Autonomous tightening of monetary policy
shifts the AD curve to the left to AD3 , and
the economy moves to point 3, where in‡ation
is at T and output is at Y3 .
Because output is below potential at point 3,
the slack in the economy shifts the SRAS curve
back to AS1 . To keep the in‡ation rate at T ,
the autonomous tightening of monetary pol-
icy will be reversed, which shifts the AD curve
back to AD1 , and eventually moves the econ-
omy back to point 1.
– As Figure 6 illustrates, stabilizing in‡ation re-
duces aggregate output to Y3 in the short run,
and only over time will output return to poten-
tial output at Y P .

Page: 9
2. RESPONSE OF MONETARY POLICY TO SHOCKS

3. Policy Stabilizes Economic Activity in the Short Run

– A third choice is for monetary policymakers to a rise in in‡ation, so in‡ation has not been
stabilize economic activity rather than in‡ation stabilized.
in the short run by lowering the real interest rate
at any given in‡ation rate, autonomously easing
monetary policy.
To stabilize economic activity, autonomous
monetary policy easing shifts the AD curve
rightward to AD3 , and the economy moves to
point 3.
At point 3, the output gap returns to zero, so
monetary policy has stabilized economic ac-
tivity, but in‡ation has risen to 3 , which is
greater than T .
– Stabilizing economic activity in response to
a temporary negative supply shock results in

Page: 10
2. RESPONSE OF MONETARY POLICY TO SHOCKS

2.4 The Bottom Line: The Relationship between Stabilizing In‡ation and Stabilizing Economic Activity

We can draw the following conclusions from our analysis:

1. If most shocks to the economy are aggregate demand shocks or permanent aggregate supply
shocks, then policy that stabilizes in‡ation will also stabilize economic activity, even in the short
run.
2. If temporary supply shocks are more common, then a central bank must choose between the
two stabilization objectives in the short run.
3. In the long run there is no con‡ict between stabilizing in‡ation and economic activity in response
to shocks including temporary supply shocks.

Page: 11
3. HOW ACTIVELY SHOULD POLICYMAKERS TRY TO STABILIZE ECONOMIC ACTIVITY?

3 How Actively Should Policymakers Try to Stabilize Economic Activity?

All economists have similar policy goals (to promote high employment and price stability), yet they often
disagree on the best approach to achieve those goals
– Suppose policymakers confront an economy that has high unemployment resulting from a negative demand
or supply shock that has reduced aggregate output.
1. Nonactivists believe that wages and prices are very ‡exible, so the self-correcting mechanism is very
rapid, and they argue that the SRAS curve will shift down, returning the economy to full employment
very quickly.
Thus, they believe government action is unnecessary to eliminate unemployment.
2. Activists, many of whom are followers of Keynes (referred to as Keynesians), regard the self-correcting
mechanism through wage and price adjustment as very slow because wages and prices are sticky. As
a result, they believe it takes a very long time to reach the long run, agreeing with Keynes’s famous
adage that "In the long run, we are all dead."
Therefore, they see the need for the government to pursue active policy to eliminate high unem-
ployment when it develops.
If policymakers could shift the AD curve "instantaneously," activist policies could be used to immediately move
the economy to the full employment level, as we have seen in the previous section.
– However, several types of lags prevent this immediate shift from occurring, and there are di¤erences in
the length of these lags for monetary policy versus …scal policy:
1. The data lag is the time it takes for policymakers to obtain data indicating what is happening in the
economy.
For example, accurate data on GDP are not available until several months after a given quarter is
over.

Page: 12
3. HOW ACTIVELY SHOULD POLICYMAKERS TRY TO STABILIZE ECONOMIC ACTIVITY?

2. The recognition lag is the time it takes for policymakers to be sure of what the data are signaling
about the future course of the economy.
For example, to minimize errors, the National Bureau of Economic Research will not declare the
economy to be in recession until at least six months after it has determined that one has begun.
3. The legislative lag is the time it takes to pass legislation to implement a particular policy
The legislative lag does not exist for most monetary policy actions, such as lowering interest rates.
However, it is important for implementation of …scal policy, when it can sometimes take six months
to a year to pass legislation to change taxes or government purchases.
4. The implementation lag is the time it takes for policy makers to change policy instruments once
they have decided on the new policy
This lag is less important for the conduct of monetary policy rather than …scal policy because the
Fed can immediately change its policy interest rate.
5. The e¤ectiveness lag is the time it takes for the policy actually to have an impact on the economy.
The e¤ectiveness lag is both long (often a year or longer) and variable (that is, there is substantial
uncertainty about how long this lag is).
– The existence of all these lags makes the policymakers’job far more di¢ cult and therefore weakens the
case for activism.
When unemployment is high, activist policy to shift the AD curve rightward to restore the economy
to full employment may not produce desirable outcome.
Indeed, if the policy lags described above are very long, then by the time the AD curve shifts to the
right, the self-correcting mechanism may have already returned the economy to full employment, so
when the activist policy kicks in it may cause output to rise above potential, leading to a rise in‡ation.

Page: 13
4. INFLATION: ALWAYS AND EVERYWHERE A MONETARY PHENOMENON

4 In‡ation: Always and Everywhere A Monetary Phenomenon

Milton Friedman’s famous adage is that in the long run "in‡ation is always and everywhere a monetary
phenomenon."
– This adage is supported by our aggregate demand and supply analysis because it shows that monetary
policymakers can target any in‡ation rate in the long run by shifting the aggregate demand curve
with autonomous monetary policy.
In Figure 8, the economy is initially at point 1, where output is at potential output Y P and in‡ation is at an
initial in‡ation target T1 .
– Suppose the central bank believes this in‡ation tonomous monetary policy adjustments.
target is too low and choose to raise it to a higher
level of T3 . 2. Potential output –and therefore the quan-
tity of aggregate output produced in the
Then, it eases monetary policy autonomously long run - is independent of monetary pol-
by lowering the real interest rate at any given icy.
in‡ation rate, thereby increasing investment
spending and aggregate demand.
As a result, the AD curve shifts to AD3 , and
the economy moves to point 2. Because out-
put is above potential (Y2 > Y P ), the SRAS
curve would shift up and to the left, eventually
stopping at AS3 , with the economy moving to
point 3, where in‡ation is at the higher target
level of T3 and the output gap is back to zero.
– The analysis demonstrates the following key
points:
1. The monetary authorities can target any
in‡ation rate in the long run with au-
Page: 14
5. CAUSES OF INFLATIONARY MONETARY POLICY

5 Causes of In‡ationary Monetary Policy

If everyone agrees that high in‡ation is bad for an economy, why do we see so much of it? Do governments
pursue in‡ationary monetary policies intentionally?
– We have seen that monetary authorities can set the in‡ation rate in the long run, so it must be that
in trying to achieve "other goals (e.g., high employment targets)," governments end up with
overly expansionary monetary policy and high in‡ation.
– Thus, we need to examine the government policies that are the most common sources of in‡ation.
The primary goal of most governments is high employment, and the pursuit of this goal can bring high in‡ation.
– In the U.S., laws requires a government’s commitment to a high level of employment consistent with
stable in‡ation.
In practice, however, the U.S. government and the Federal Reserve have often pursued a high employ-
ment target with little concern about the in‡ationary consequences of policies.
This tendency was true especially in the mid-1960s and 1970s, when the government and the Fed
began to take an active role in attempting to stabilize unemployment.
– Two types of in‡ation can result from an activist stabilization policy to promote high employment:
1. Cost-push in‡ation results either from a temporary negative supply shock or a push by workers for
wage hikes beyond what productivity gains can justify.
2. Demand-pull in‡ation results from policymakers pursuing policies that increase aggregate demand.
– In what follows, we use our aggregate demand and supply analysis to examine the e¤ects of a high
employment target on both types of in‡ation.

Page: 15
5. CAUSES OF INFLATIONARY MONETARY POLICY

5.1 Cost-Push In‡ation

Let’s look at Figure 9 in which the economy is ini- – So, the workers fare quite well, earning
tially at point 1, the intersection of AD1 and AS1 . both high wages and government protec-
tion against excessive unemployment.
Now, suppose that workers succeed in pushing for
higher wages, either because they want to increase – The workers’success might encourage them
their real wages above what is justi…ed by produc- to seek even higher wages, and in addition,
tivity gains, or because they expect in‡ation to be other workers might seek wage increases –
high and wish their wages to keep up with it. another temporary negative supply shock
would occur, which shifts the SRAS curve.
– This cost-push shock, which acts like a tem-
porary negative supply shock, raise the in- This supply shock promotes "activist
‡ation rate and shifts the SRAS curve up and policies" once again to shift the AD
to the left to AS2 . curve, leading to an even higher in-
‡ation rate.
Then, there are two possible choices:
– If this process continues, the result will
1. If the central bank takes no action, then the be a continuing increase in in‡ation – a
0
economy would move to point 2 , the intersec- cost-push in‡ation.
tion of AS2 and AD1 –output would decline to
Y 0 below potential and in‡ation would rise to
20 , leading to an increase in unemployment.

2. In contrast, activist policymakers with a high

employment target would implement policies,
such as a cut in taxes, an increase in gov-
ernment purchases, or an autonomous easing
of monetary policy, to increase aggregate de-
mand. These policies would shifts the AD
curve to AD2 , quickly returning the economy
to potential output at point 2 and increasing
the in‡ation rate to 2 .

Page: 16
5. CAUSES OF INFLATIONARY MONETARY POLICY

5.2 Demand-Pull In‡ation

The unemployment rate at full employment (the – Because the target rate of unemployment is be-
natural rate of unemployment) is greater than zero. low the natural rate level, wages will rise and
the SRAS curve will shift up and to the left
– When policymakers mistakenly underestimate from AS1 to AS2 to AS3 and so on.
the natural rate of unemployment and so set a
target for unemployment that is too low, they – The result is a continuing rise in in‡ation
set the stage for expansionary monetary and known as a demand-pull in‡ation.
…scal policy that produces in‡ation.
As described below, policymakers fail on
two counts: They have not achieved their
unemployment rate and have caused higher
in‡ation.
In Figure 10, too low an unemployment target
(equivalently, too high an output target of Y T
greater than potential output Y P ) causes the gov-
ernment to increase aggregate demand by imple-
menting policies such as expansionary …scal policy
or an autonomous easing of monetary policy, which
shifts the AD curve rightward from AD1 to AD2 to
AD3 and so on.

Page: 17
5. CAUSES OF INFLATIONARY MONETARY POLICY

5.3 Cost-Push versus Demand-Pull In‡ation

When in‡ation occurs, how do we know whether it is demand-pull or cost-push in‡ation?

– We would normally expect to see demand-pull in‡ation when unemployment is below the natural rate
level, and cost-push when unemployment is above the natural rate level.
– However, this basis cannot be easily applied:
1. Unfortunately, economists and policymakers still struggle with measuring the natural rate of unem-
ployment.
2. Complicating matters further, a cost-push in‡ation can be initiated by a demand-pull in‡ation, blurring
the distinction.
When a demand-pull in‡ation produces higher in‡ation rates, expected in‡ation will eventually rise
and cause workers to demand higher wages (cost-push in‡ation) so that their real wages do not fall.
3. Finally expansionary monetary and …scal policies produces both kinds of in‡ation, so we cannot dis-
tinguish them on this basis.
In the U.S., as we will see in the following application, the primary reasons for in‡ationary policy has been
policymakers’adherence to a high employment target.
– As we saw in Chapter 20, high in‡ation can also occur because of persistent government budget de…cits.

Page: 18
5. CAUSES OF INFLATIONARY MONETARY POLICY

5.4 Application: The Great In‡ation

Now that we have examined the roots of in‡ationary monetary policy, we can investigate the causes of the rise
in U.S. in‡ation from 1965 to 1982, a period dubbed the "Great In‡ation."
– Both demand-pull and cost-push in‡ation led to the Great In‡ation from 1965 to 1982.

1. Panel (a) documents the rise in in‡ation during This indicates that after 1975 the economy
those years: was the phenomenon of a cost-push in‡a-
tion (the impetus for which was the earlier
(a) Before the Great In‡ation started, the in‡ation demand-pull in‡ation), which we described
rate was below 2% at an annual rate. in Figure 9.
(b) By the late 1970s, it averaged around 8% and
peaked at nearly 14% in 1980 after the oil price
shock in 1979.
2. Panel (b) compares the actual unemployment rate
to estimates of the natural rate of unemployment:
(a) The economy experienced unemployment be-
low the natural rate in all but one year between
1960 and 1973.
This insight suggests that in 1965–
1973, the U.S. economy experienced the
demand-pull in‡ation we described in Fig-
ure 10.
(b) After 1975, the actual unemployment rate lin-
gered about the natural rate of unemployment,
yet in‡ation continued.

Page: 19
5. CAUSES OF INFLATIONARY MONETARY POLICY

More details on in‡ation for two periods are as fol- the demand-pull in‡ation shifted the SRAS
lows: curve in Figure 9 upward and to the left,
causing a rise in unemployment that policy-
1. In 1965–1973, the U.S. economy experienced makers tried to eliminate by autonomously
the demand-pull in‡ation we described in Fig- easing monetary policy, shifting the AD
ure 10. curve to the right.
– That is, policymakers pursued a policy – The result was a continuing rise in in‡ation.
autonomous monetary policy easing that
shifted the AD curve to the right in try-
ing to achieve an output target that was
too high, thus increasing in‡ation.
– In the mid-1960s, policymakers, econo-
mists, and politicians were committed to a
target unemployment rate of 4%, a level of
unemployment they believed to be consis-
tent with price stability. In hindsight, most
economists today agree that the natural
rate was substantially higher in the 1960s
and 1970s between 5% and 6%.
2. After 1975, the economy was the phenomenon
of a cost-push in‡ation (the impetus for which
was the earlier demand-pull in‡ation), which
we described in Figure 9.
– The public’s knowledge that government
policy was aimed squarely at high employ-
ment explains the persistence of in‡ation.
The higher rate of expected in‡ation from

Page: 20