The challenges of Monetary Policy

The Great Depression led many to believe that government must play a more active role in the economy in order to stop the periods of unemployment and subsequent rebound where there was inflation.

This line of thinking was advocated by John Maynard Keynes and it caught on after WWII. (Note the build-up to the war led US out of depression, which seemed to confirm the necessary role of government.

Keynes taught that fiscal policy was the key to smoothing boom-bust cycles.

After WWII the economy was good. Relatively steady expansion. This changed in the 1970s. In the 1970s a new term was introduced: stagflation: high unemployment coupled with high inflation. This led many to question the role of government.

The government (in particular the Fed) has not been universally successful in controlling the economy. We have had 10 recessions since the Depression, BUT the severity and length of them seem to have been reduced.

However, this improvement has not come easy. AS we have seen throughout the year, the FED faces many challenges.

What should be the goals of the Fed?

Many believe to keep inflation in check. Others to keep unemployment low. Others growth.

These goals are often conflicting.

Tools:

Monetary Policy: the costs and availability of funds

Fiscal policy: government spending and tax policy.

Reagan! J

Economy depends on growth of capital, labor, and productivity. These, in turn, are influenced by many things. In particular capital "depends directly on the amount of investment spending undertaken by firms."

Further R&D increases productivity. Also training improves labor productivity.

Thus capacity increases if things are going well.

Tax policy can influence labor supply as well as corporate R&D. While government subsidies for education can improve labor productivity.

Moreover, if the FED is successful in controlling boom/bust cycles, the risk of investments is reduced and firms will be more willing to spend on capital improvements.

Why is inflation a concern?

It is easy to understand why the Fed may focus on unemployment rates, but less easy to see why inflation is a concern. Isn’t it just moving the decimal place?

Inflation is a concern for several reasons:

1. difficulty in planning
2. Households are net lenders. Thus inflation would be detrimental to savings.
3. Price changes and incomes would not change at same rate and real income would fluctuate.

As the world becomes more dependent on international trade, it becomes more difficult to control the economy of any one nation. For example: inflation now depends on foreign demand. Or as we saw in the recent Asian crisis, deflation becomes a real concern.

The Fed must tell Congress what the goals of the Fed are. Humphrey-Hawkins testimony occurs in front of Congress in February and July of each year. Policy makers are to "pursue policies consistent with achieving full employment and non-inflationary growth."

Are the two conflicting? In some ways they are. It is also interesting to note that different countries emphasize one or the other to varying degrees. As the text points out, Germany is much more focused on preventing inflation.

What does noninflationary mean?

Varies by what we have recently seen. For example 3.5% was considered high and even led Nixon to issue a wage and price freeze. Now 3.5% is considered low. Everything is relative and the key is our expectations. Shocks and surprises are not liked!

What does Full-employment mean?

It is defined as the lowest rate of unemployment consistent with stable prices. (book claims 4.5-5% current rate is approximately 4.1%)

Based on history, most believe long-run GDP growth can be sustained at 2.5-3%.

We have seen repeatedly how the Fed can influence aggregate demand. For example, to slow demand, the Fed raises Interest rates.

However, the Fed may raise rates too far. Too much raising can lead to a demand-induced Recession where by through lowering spending, the Fed actually may inadvertently cause a recession. Thus the Fed must walk the thin line between too fast and too slow of growth.

We have not focused much on the role Congress might have on the economy through its fiscal policy.

Government spending can be thought of as a irrigation system. During a drought you water more than you do in a wet-season. Similarly, government spending should fluctuate to lessen business cycles. For example, when the country is in a slow period, government spending can be used to get the economy going again. (remember that government spending increases aggregate demand just like household spending.)

How does this fit with a Balance Budget amendment? Not very well. In a recession inflows (tax receipts) would fall. This would lead to reduced government spending at the very time when the spending should increase.

One point that can not be overlooked is that of expectations. Expectations drive everything. If people believe the Fed will control inflation, the investment decisions will be vastly different than if the Fed has lost the confidence of the people. Once inflation is here, it is too late.

Historically inflation has come about in one of two ways:

1. Increased demand (that is inflation increases as economy picks up)

2. Increased Cost-push inflation: where input-prices rise (example oil prices in 1970s).