Monetary policy theory

1. INTERNATIONAL FINANCE

2. Chapter 24
Monetary Policy Theory
Prof. PhD. Tran Ngoc Tho

3.  We use the aggregate demand–aggregate supply (AD/AS).
We will examine the role of monetary policy in creating inflation
and stabilizing the economy. We apply the theory to three big
questions: What are the roots of inflation? Does stabilizing
inflation stabilize output? Should policy be activist-by
responding aggressively to fluctuations in economic activity-or
passive and nonactivist?
 Between September 2007 and December 2008, the Federal
Reserve lowered the target for its policy interest rate, the
federal funds rate, from 5,25% all the way down to zero and
continued to keep it there for years afterward. Why did the Fed
lower interest rates this aggressively and continue to keep
them so low? Could this monetary policy easing spark
undesirable inflation?

4. HOW ACTIVELY
SHOULD
POLICYMAKERS
TRY TO
STABILIZE
ECONOMIC
ACTIVITY?
INFLATION:
ALWAYS AND
EVERYWHERE
A MONETARY
PHENOMENON
CAUSES OF
INFLATIONARY
MONETARY
POLICY
Response
to a
Permanent
Supply
Shock
Response
to a
Temporary
Supply
Shock
Lags and
Policy
Implemen
tation
High
Employment
Targets and
Inflation
The
Relationship
Between
Stabilizing
Inflation and
Stabilizing
Economic
Activity
Monetary Policy Theory
RESPONSE OF
MONETARY
POLICY TO
SHOCKS
Response
to an
Aggregate
Demand
Shock

5.  The central goal of central banks is price stability: that is,
they try to maintain inflation, π, close to a target level
(πT), referred to as an inflation target, that is slightly
above zero.
 The central bank pursues price stability is that monetary
policy should try to minimize the difference between
inflation and the inflation target (π - πT ), which we refer
to as the inflation gap.

6.  Central banks also care about stabilizing economic activity.
Because economic activity can be sustained only at
potential output, so they want to have aggregate output
close to its potential level, YP
 Central banks want to minimize the difference between
aggregate output and potential output (Y − YP ), i.e., the
output gap.

7.  In the case of both demand shocks and permanent supply
shocks, policymakers can simultaneously pursue price
stability and stability in economic activity.
 Following a temporary supply shock, however,
policymakers can achieve either price stability or economic
activity stability, but not both.

8.  Response to an Aggregate Demand Shock
 No Policy
Response
Policymakers
can respond
to this shock
in two
possible
ways:
 Policy
Stabilizes
Economic
Activity and
Inflation in
the Short
Run

9. Inflation Rate, π
𝒀 𝑷𝒀 𝟐
𝑨𝑺 𝟏
𝑨𝑺 𝟐
𝝅 𝟑
𝝅 𝟐
𝝅 𝑻
𝑨𝑫 𝟏
𝑨𝑫 𝟐
2
1
3
LRAS
Aggregate Output, Y
Step 1: The
aggregate demand
curve shifts
leftward…
Step 2: Decreasing
output and inflation
until…
Step 3: The
economy
returns to long-
run equilibrium,
with inflation
permanently
decreased.
FIGURE 1 Aggregate Demand Shock: No Policy Response

10.  No Policy Response
At first glance, this outcome
looks favorable—inflation is
lower and output is back at its
potential. But aggregate output
will remain below potential for
some time.

11.  Policy Stabilizes Economic Activity and
Inflation in the Short Run
Policymakers can eliminate both the output gap and the
inflation gap in the short run by pursuing policies to increase
aggregate demand to its initial level and return the economy
to its preshock state. The central bank does this by
autonomously easing monetary policy by cutting the real
interest rate at any given inflation rate.

12. Inflation Rate, π
𝒀 𝑷𝒀 𝟐
𝑨𝑺 𝟏
𝝅 𝟐
𝝅 𝑻
𝑨𝑫 𝟏
𝑨𝑫 𝟐
2
1
LRAS
Aggregate Output, Y
Step 2: Decreasing
output and inflation.
Step 1: The aggregate
demand curve shifts
leftward…
Step 3: Autonomous easing of
monetary policy shifts the
aggregate demand curve back
to 𝐴𝐷1 and the economy
returns to long-run equilibrium,
with inflation stabilized at π 𝑇
.
FIGURE 2 Aggregate Demand Shock: Policy Stabilizes
Output and inflation in the Short run
3

13.  In the case of aggregate demand shocks, there is no
tradeoff between the pursuit of price stability and economic
activity stability.
 A focus on stabilizing inflation leads to exactly the right
monetary policy response to stabilize economic activity. No
conflict exists between the dual objectives of stabilizing
inflation and economic activity which Olivier Blanchard
referred to as the divine coincidence.

14.  We have seen that monetary policymakers can counter
aggregate demand shocks and stabilize output and
inflation by lowering the real interest rate.
 However, sometimes the negative
aggregate demand shock is so
large that at some point the central
bank cannot lower the real interest
rate further because the nominal
interest rate hits a floor of zero.

15. Quantitative easing (QE). How did quantitative (credit)
easing work to stabilize output and inflation during the
global financial crisis?

16.  In late 2008, the Lehman
Brothers collapsed, the real
cost of borrowing to both
households and businesses
shot up because financial
frictions rose dramatically ( 𝑓 ↓)
 By engaging in asset
purchases and liquidity
provision, the Fed was able to
reduce financial frictions ( 𝑓 ↓)
and lower the real cost of
borrowing to households and
businesses.

17. Inflation Rate, π
𝒀 𝑷𝒀 𝟐
𝑨𝑺 𝟏
𝝅 𝟐
𝝅 𝑻
𝑨𝑫 𝟏
𝑨𝑫 𝟐
2
1
LRAS
Aggregate Output, Y
Step 2: Decreasing
output and inflation.
Step 1: The aggregate
demand curve shifts
leftward…
Step 3: Autonomous easing of
monetary policy shifts the
aggregate demand curve back
to 𝐴𝐷1 and the economy
returns to long-run equilibrium,
with inflation stabilized at π 𝑇
.
FIGURE 2 Aggregate Demand Shock: Policy Stabilizes
Output and inflation in the Short run
3

18.  No Policy
Response
There are
two possible
policy
responses to
a permanent
supply shock:
 Policy
Stabilizes
Inflation

19. 𝒀 𝑷
Inflation
Rate, π
Step 1. A permanent negative
supply shock shifts the long-run
aggregate supply curve leftward
. . .
Step 2. and the short-run
aggregate supply curve shifts
upward until . . .
Step 3. the economy returns
to long-run equilibrium, with
output falling and inflation
rising.
Aggregate Output, Y
LRAS1LRAS3
𝝅 𝟑
𝒀 𝑷
Y2
𝝅 𝟐
𝝅 𝑻
3
2
1
AS2
AS3
AD1
AS1
3 1
Figure 3 permanent Supply Shock: No policy response

20.  No Policy Response
The economy moves to point 3,
eliminating the output gap but
leaving inflation higher at 𝜋3 and
output lower at Y3
P
.

21. Aggregate Output, Y
Inflation
Rate, 𝛑
AS1
AD1
LRAS1
AS3
AD3
LRAS3
𝒀 𝑷
𝒀 𝑷
3 1
1
2
3𝝅 𝑻
𝝅 𝟐
Figure 4 Permanent Supply Shock: Policy Stabilizes Inflation
Step 2. Autonomous
Monetary policy
tightening
shifts the aggregate
Demand curve to AD3
and the economy
returns to
long-run equilibrium with
ination stabilized at 𝜋
𝑇
.
Step 1. A permanent negative
supply shock shifts the long-run
aggregate supply curve
leftward.

22.  Policy Stabilizes Inflation
Stabilizing inflation has stabilized economic activity.
The divine coincidence still remains true when a
permanent supply shock occurs: There is no
tradeoff between the dual objectives of stabilizing
inflation and economic activity.

23.  Policymakers can respond to the temporary supply
shock in three possible ways
• No Policy Response
• Policy Stabilizes Inflation in the Short Run
• Policy Stabilizes Economic Activity in the Short Run
 When a supply shock is temporary, such as when the price of
oil surges because of political unrest in the Middle East or
because of an act of god, such as a devastating hurricane in
Florida, the divine coincidence does not always hold.
Policymakers face a short-run tradeoff between stabilizing
inflation and economic activity.

24. AS2
AS1
LLRAS1
AD1
1
2
Inflation
Rate, 
Aggregate Output, YYPY2
2
T
FIGURE 5 Response to a Temporary Aggregate Supply Shock:
No Policy Response
Step 1. A temporary
negative supply shock
shifts the aggregate
supply curve upward . . .
Step 2. temporarily
increasing inflation
and decreasing
output.
Step 3. Inflation and
economic activity will
stabilize in the long run.

25.  No Policy Response
 In the long run, there is no
tradeoff between the two
objectives, and the divine
coincidence holds.

26. Inflation
Rate, 
Aggregate Output, Y
AS2
AS1
AD1
AD3
2
T
LRAS1S
1
2
3
YPY2Y3
FIGURE 6 Response to a Temporary Aggregate Supply Shock:
Short-run Inflation Stabilization
Step 1. A temporary
negative supply shock shifts
the aggregate supply curve
upward.
Step 2. Autonomous tightening of
monetary policy shifts the aggregate
demand curve to AD3, leading to a
decline in output, but keeping
inflation
at T
Step 3. The aggregate
supply curve shifts
downward . . .
Step 4. leading policy
makers to
autonomously ease
monetary policy to shift
the aggregate demand
curve back to AD1
stabilizing inflation and
output in the long run.

27.  Policy Stabilizes Inflation in the Short Run
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.

28. LRAS
𝒀 𝒑
Inflation
Rate, 𝝅
Aggregate Output, Y
𝝅 𝟐
𝝅 𝟑
AS 𝟐
A𝑫 𝟏
A𝑫 𝟐
AS 𝟏
3
2
Step 1. A temporary
negative supply shock
shifts the aggregate supply
curve upward
Step 2. leading to a rise in
inflation and a fall in
output.
Step 3. Autonomous easing
of monetary policy shifts the
AD curve rightward.
Step 4. Output has stabilized at
potential, but inflation is higher
than the target level.
1
FIGURE 7 Response to a Temporary Aggregate Supply
Shock: Short-run Output Stabilization
Y2
𝝅 𝑻

29.  Policy Stabilizes Economic Activity in
the Short Run
 Stabilizing economic activity in response to a
temporary supply shock results in a rise in inflation,
so inflation has not been stabilized.

30. We can draw the following conclusions from this analysis:
1. If most shocks to the economy are aggregate demand
shocks or permanent aggregate supply shocks, then policy
that stabilizes inflation 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 conflict between stabilizing
inflation and economic activity in response to shocks.

31.  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
 Nonactivists believe wages and prices are very flexible.
They thus believe government action is unnecessary to
eliminate unemployment.
 Activists, many of whom are followers of Keynes and are
thus referred to as Keynesians ,regard the self-correcting
mechanism through wage and price adjustment as very slow
because wages and prices are stick. They therefore see the
need for the government to pursue active policy to eliminate
high unemployment when it develops.

32. If policymakers could shift the aggregate demand
curve instantaneously, activist policies could be used to
immediately move the economy to the full-employment
level. However, several types of lags prevent this
immediate shift from occurring, and there are
differences in the length of these lags for monetary
versus fiscal policy.

33.  The data lag The time it takes for policymakers to obtain
data indicating what is happening to the economy.
 The recognition lag The time it takes for policymakers
to be sure of what the data are signaling about the future
course of the economy.
 The legislative lag The time it takes to pass legislation
to implement a particular policy.
 The implementation lag The time it takes for
policymakers to change policy instruments once they
have decided on a new policy.
 The effectiveness lag The time it takes for a policy to
actually have an impact on the economy.

34.  Milton Friedman is famous for his adage that in the long
run “Inflation is always and everywhere a monetary
phenomenon.”
 To illustrate, look at Figure 8, where the economy is at
point 1, with aggregate output at potential output YP and
inflation at an initial inflation target of 1
T

35. LRAS
𝒀 𝒑
Inflation
Rate, 𝝅
Aggregate Output, Y
𝝅 𝟐
AS 𝟐
A𝑫 𝟏
A𝑫 𝟐
AS 𝟏
3
2
Step 1. Autonomous monetary
policy easing shifts the AD curve to
the right, and over time, the short-
run aggregate supply curve shifts
upward . . .
Step 2. and inflation
rises to the new, higher
target.
1
FIGURE 8 A Rise in the Inflation Target
Y2
𝝅 𝟑
𝑻
𝝅 𝟏
𝑻

36. The analysis in Figure 8 demonstrates the following key
points:
1. The monetary authorities can target any inflation
rate in the long run with autonomous monetary
policy adjustments.
2. Potential output—and therefore the quantity of
aggregate output produced in the long run—is
independent of monetary policy.

37.  The primary goal of most governments is high
employment, and the pursuit of this goal can bring high
inflation.
 Two types of inflation can result from an activist
stabilization policy to promote high employment:
1. Cost-push inflation
2. Demand-pull inflation

38.  Cost-Push Inflation
Definition:
Cost-push inflation is when supply costs
increase or the level of supply
decreases. Prices rise in the final good
or service if demand remains the same.

39.  Cost-Push Inflation
Causes (demand is inelastic):
1.Wage inflation..
2.Companies that achieve a monopoly over an industry reduces
supply.
3.Natural disasters.
4.Government regulation and taxation.
5.Exchange rates.

40. Inflation
rate,π
Aggregate output,Y
LRAS AS4
AS3
AS2
AS1
AD1
AD2
AD3
AD4
 1
 2
 3
 4
2’ 
3 ’ 
4’ 
π4
π3
π2
π1
π2'
Y’ YP
Step 1: A temporary negative supply
shock shifts the short-run aggregate
supply curve upward...
Step 2: causing output to fall
and unemployment to
increase
Step 3: policy makers increase
aggregate demand in response..
Step 4: leading to an
spiraling rise in inflation

41.  Demand-Pull Inflation
Definition:
Demand-pull inflation is results from policymakers pursuing
policies that increase aggregate demand. Typically, sellers
meet such an increase with more supply. But when
additional supply is unavailable, sellers raise their prices.
That results in demand-pull inflation.

42. Causes:
1. Discretionary fiscal policy
2. A growing economy
3. The expectation of inflation
4. A strong brand
5. Technological innovation
 Demand-Pull Inflation

43. Inflation
rate,π
Aggregate output,Y
LRAS
AS1
AD1
YP
 1π1
Step 1: Policy makers increase
aggregate demand to reach a
higher output target...
AD2
 2’
π2
YT
Step 2: causing AS to shift upward in
response to rising wages...
AS2
 2
Step 3:leading to a spiralling
rise in inflation
AD3
 3’
AS3
 3π3
AD4
 4’
AS4
 4π4

44. We cannot distinguish between them on this basis demand-
pull inflation when unemployment is below the natural rate
level, and cost-push inflation when unemployment is above the
natural rate level. Unfortunately, economists and policymakers
still struggle with measuring the natural rate of unemployment.
 Cost-Push Versus Demand-Pull Inflation

45.  A cost-push inflation can be initiated by a demand-pull
inflation, blurring the distinction. When a demand-pull
inflation. Produces higher inflation rates, expected
inflation will eventually rise and cause workers to
demand higher wages (cost-push inflation) so that their
real wages do not fall.
 High inflation can also occur because of persistent
government budget deficits.
 Cost-Push Versus Demand-Pull Inflation

46. Now that we have examined the roots of
inflationary monetary policy, we can investigate
the causes of the rise in U.S. inflation from 1965
to 1982, a period dubbed the “Great Inflation.”

47. The CPI inflation rate was below 2% at
an annual rate in the early 1960s, but by
the late 1970s, it was averaging around
8% and peaked at over 14% in 1980
after the oil price shock in 1979.

48. The economy experienced
unemployment below the
natural rate in all but one year
between 1960 and 1973,
suggesting a demand-pull
inflation described in Figure 10.
That is, policymakers pursued
a policy of autonomous
monetary policy easing that
shifted the aggregate demand
curve to the right in trying to
achieve an output target that
was too high, thus increasing
inflation.

49. FIGURE 10 Demand-Pull Inflation

50. After 1975, the
unemployment rate was
regularly above the natural
rate of unemployment,
suggesting a cost-push
inflation as delineated in
Figure 9.

51. FIGURE 9 Cost-Push Inflation

52. The public’s knowledge that
government policy was aimed
squarely at high employment explains
the persistence of inflation. The
higher rate of expected inflation from
the demand-pull inflation shifted the
short-run aggregate supply curve in
Figure 9 upward and to the left,
causing a rise in unemployment that
policymakers tried to eliminate by
autonomously easing monetary
policy, shifting the aggregate
demand curve to the right. The
result was a continuing rise in
inflation.

53. Only when the Federal Reserve
committed to an anti-inflationary
monetary policy under Chairman Paul
Volcker, which involved hiking the federal
funds rate to the 20% level, did inflation
come down, ending the Great Inflation

54. 1. For aggregate demand shocks and permanent
supply shocks the price stability and economic
activity stability objectives are consistent:
Stabilizing inflation stabilizes economic activity
even in the short run. For temporary supply
shocks, however, there is a tradeoff between
stabilizing inflation and stabilizing economic
activity in the short run. In the long run,
however, no conflict arises between stabilizing
inflation and economic activity.

55. 2. Activists regard the self-correcting mechanism
through wage and price adjustment as very
slow and hence see the need for the
government to pursue active, accommodating
policy to address high unemployment when it
develops. Nonactivists, by contrast, believe
that the self-correcting mechanism is fast and
therefore advocate that the government avoid
active policy to eliminate unemployment.

56. 3. Milton Friedman’s view that in the long-run
inflation is always and everywhere a monetary
phenomenon is borne out by aggregate demand
and supply analysis: It shows that monetary
policymakers can target any inflation rate in the
long run they want through autonomous
monetary policy, which adjusts the equilibrium
real interest rate using the federal funds rate
policy tool to change the level of aggregate
demand.

57. 4.Two types of inflation can result from an activist
stabilization policy to promote high employment:
cost-push inflation, which occurs because of
negative supply shocks or a push by workers to get
higher wages than is justified by productivity gains;
and demand-pull inflation, which results when
policymakers pursue high output and employment
targets through policies that increase aggregate
demand. Both demand-pull and cost-push inflation
led to the Great Inflation from 1965 to 1982.