Monetary and Fiscal Policy
Monetary and Fiscal Policy Summary • Operating target of monetary policy • The liquidity trap
Operating target of monetary policy • How should a central bank conduct monetary policy to meet its objectives? • What instrument or operating target should it use? • Instruments/operating targets: ○ Mone y supply ○ Interest rate
Objectives of central bank ○ Range of objectives: Price stability (low inflation Stabilizing output growth or employment Financial stability ○ We suppose the primary concern is price stability (strictly as zero inflation)
Shocks ○ We consider 3 different shocks that the economy may face: Money demand shock Output demand shock Output supply shock ○ How do the 2 operating targets perform in response to these shocks? ○ Problem for central bank: It doesn't have timely information about these shocks so cannot adjust its instrument in response Shift in money demand Graph demonstrating the effect of a money demand shock
• Shock shifts money demand → • If MS fixed, then PL ↓ from P1 to P2 • Price stability requires MS ↑ to shift MS →
Course Notes Page 71
Shift in output demand Graph demonstrating the effect of an output demand shock
• Output demand → : Income ↑ and interest rate ↑ • MD → if income effect dominates • Price level ↓ if MS remains constant • Price stability requires MS ↑ Shift in output supply Graph demonstrating the effect of an output supply shock
• Output supply → : Income ↑ and interest rate ↓ • MD → • Price level ↓ if MS remains constant • Price stability requires MS ↑
Monetary target: performance ○ Use of MS as instrument of monetary policy performs badly in response to all three shocks Undesirable PC fluctuations occur Analysis assumed flexible prices, so there are no consequences for real variables Given sticky prices, monetary targeting would lead to undesirable fluctuations in real output
Interest rate target ○ How do we implement interest rate operating target? Central bank sets nominal interest rate R Real interest rate r determined in goods market Course Notes Page 72
Operating target of monetary policy • How should a central bank conduct monetary policy to meet its objectives? • What instrument or operating target should it use? • Instruments/operating targets: ○ Mone y supply ○ Interest rate
Objectives of central bank ○ Range of objectives: Price stability (low inflation Stabilizing output growth or employment Financial stability ○ We suppose the primary concern is price stability (strictly as zero inflation)
Shocks ○ We consider 3 different shocks that the economy may face: Money demand shock Output demand shock Output supply shock ○ How do the 2 operating targets perform in response to these shocks? ○ Problem for central bank: It doesn't have timely information about these shocks so cannot adjust its instrument in response Shift in money demand Graph demonstrating the effect of a money demand shock
• Shock shifts money demand → • If MS fixed, then PL ↓ from P1 to P2 • Price stability requires MS ↑ to shift MS →
Course Notes Page 71
Shift in output demand Graph demonstrating the effect of an output demand shock
• Output demand → : Income ↑ and interest rate ↑ • MD → if income effect dominates • Price level ↓ if MS remains constant • Price stability requires MS ↑ Shift in output supply Graph demonstrating the effect of an output supply shock
• Output supply → : Income ↑ and interest rate ↓ • MD → • Price level ↓ if MS remains constant • Price stability requires MS ↑
Monetary target: performance ○ Use of MS as instrument of monetary policy performs badly in response to all three shocks Undesirable PC fluctuations occur Analysis assumed flexible prices, so there are no consequences for real variables Given sticky prices, monetary targeting would lead to undesirable fluctuations in real output
Interest rate target ○ How do we implement interest rate operating target? Central bank sets nominal interest rate R Real interest rate r determined in goods market Course Notes Page 72
