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Monetary policy and short term demand management
  1. 1. Introduction
  2. How Do Fiscal and Monetary Policies Affect Aggregate Demand?
  3. How Do Fiscal and Monetary Policies Affect Aggregate Demand?
  4. Fiscal and Monetary Policy Actions in the Short Run
  5. Lesson summary: Fiscal and monetary policy actions in the short run (article) | Khan Academy

For the period from the mids up through the end of , Federal Reserve monetary policy can largely be summed up by looking at how it targeted the federal funds interest rate using open market operations.

1. Introduction

Of course, telling the story of the U. The nine episodes of Federal Reserve action outlined in the sections below also demonstrate that the central bank should be considered one of the leading actors influencing the macro economy. As noted earlier, the single person with the greatest power to influence the U. The graph shows the federal funds interest rate remember, this interest rate is set through open market operations , the unemployment rate , and the inflation rate since Different episodes of monetary policy during this period are indicated in the figure.

Monetary Policy, Unemployment, and Inflation. Through the episodes shown here, the Federal Reserve typically reacted to higher inflation with a contractionary monetary policy and a higher interest rate, and reacted to higher unemployment with an expansionary monetary policy and a lower interest rate.

Consider Episode 1 in the late s. By , inflation was down to 3. In Episode 2, when the Federal Reserve was persuaded in the early s that inflation was declining, the Fed began slashing interest rates to reduce unemployment. The federal funds interest rate fell from In response, the Federal Reserve used contractionary monetary policy to raise the federal funds rates from 6. In Episode 4, in the early s, when the Federal Reserve was confident that inflation was back under control, it reduced interest rates, with the federal funds interest rate falling from 8. As the economy expanded, the unemployment rate declined from 7.

Inflation did not rise, and the period of economic growth during the s continued. Then in and , the Fed was concerned that inflation seemed to be creeping up so it raised the federal funds interest rate from 4. By early , inflation was declining again, but a recession occurred in Between and , the unemployment rate rose from 4. In Episodes 7 and 8, the Federal Reserve conducted a loose monetary policy and slashed the federal funds rate from 6.

They actually did this because of fear of Japan-style deflation; this persuaded them to lower the Fed funds further than they otherwise would have. The recession ended, but, unemployment rates were slow to decline in the early s. When the Fed had taken interest rates down to near-zero by December , the economy was still deep in recession. Open market operations could not make the interest rate turn negative. The most powerful and commonly used of the three traditional tools of monetary policy—open market operations—works by expanding or contracting the money supply in a way that influences the interest rate.

In late , as the U. With the recession still ongoing, the Fed decided to adopt an innovative and nontraditional policy known as quantitative easing QE. This is the purchase of long-term government and private mortgage-backed securities by central banks to make credit available so as to stimulate aggregate demand. Quantitative easing differed from traditional monetary policy in several key ways. First, it involved the Fed purchasing long term Treasury bonds , rather than short term Treasury bills. The logic was the following: investment spending decisions are typically based on long term interest rates.

Home mortgages, for example, have maturities up to 30 years. With traditional monetary policy, the idea is that since short term and long term interest rates tend to rise or fall together, lowering short term rates will ultimately lower long term rates and stimulate investment spending. Quantitative easing attempted to skip the middle step and directly lower long-term interest rates.

This leads to a second way QE is different from traditional monetary policy. Instead of purchasing Treasury securities, the Fed also began purchasing private mortgage-backed securities, something it had never done before. The quantitative easing policies adopted by the Federal Reserve and by other central banks around the world are usually thought of as temporary emergency measures. Monetary policy continued to help the situation when, at the end of , the ECB introduced two three-year longer-term refinancing operations implemented in December and February amounting to EUR 1 trillion.

This measure and the correction of the two rate hikes contributed to attenuate the severity of the recession. The programme facilitated an ease of tension in all financial markets, which was accompanied by a slow, but progressive return of spreads towards normal levels.


How Do Fiscal and Monetary Policies Affect Aggregate Demand?

Altogether, with the second round of sovereign bond purchases in , the liquidity supplied at end and the OMT announcement, the ECB put an end to the euro area acute existential crisis. This brings me to the fourth and current phase of monetary policy in the euro area. In , the euro area recovery had not yet gained traction.

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In spite of the ultra-low level of interest rates, renewed deflationary risks emerged with a progressive fall of inflation towards levels significantly below 2 percent. In contrast with the previous five years, financial disruptions could no longer be responsible for the economic slowdown. The coincident reduction of output and inflation suggested that the renewed economic weakness was driven by a negative aggregate demand shock.

In turn, the negative demand shock could be the delayed result of the fiscal policy tightening since , or possibly the consequence of weakened economic sentiment after two recessions.

Maintaining price stability in the face of insufficient aggregate demand and downward inflationary pressures required a more expansionary monetary policy stance. In response to these developments, a new phase in non-standard measures was launched, including increasing the balance sheet with asset purchases. The new non-standard policies were not merely expected to undo any remaining financial market impairments, but to further ease the monetary policy stance at a point where policy rates had reached their lower bound.

In January , the large-scale asset purchase programme APP was extended to include purchases of sovereign bonds. A growing number of studies about the impact of APP suggest that the programme was effective in lowering spreads on long-maturity assets and thereby boosting inflation and growth. From a simpler perspective, we can state today that three years of large-scale asset purchases have eliminated the risk of prolonged deflation. This fact is incontrovertible and should be admitted by both the early APP critics and those who claimed it was unnecessary.

I think that making progress in our theoretical understanding of QE remains an important research priority for central banks, especially in view of the possibility that nominal interest rate will be more persistently low in the future, and thus that the effective lower bound constraint will be hit more frequently. A particular aspect of QE programmes that needs to be investigated further regards its distributional effects. As an instrument of monetary policy accommodation, the APP led to an increase in economic activity, which was especially beneficial for those individuals who, as a result, found a job after being unemployed.

At the same time, the APP increased the value of financial assets and thus led to capital gains for the holders of those assets.

How Do Fiscal and Monetary Policies Affect Aggregate Demand?

Improving our understanding of the relative strength of these distributional effects is also an important priority for central banks. Ongoing work at the ECB suggests that the decline in unemployment that followed the introduction of the APP had a disproportionately positive impact on low-income households.

Furthermore, as a result of housing price increases associated with the economic recovery, the same positive outcome took place with respect to wealth distribution. The ECB journey that I have recalled here can give rise to two obvious questions. The first one relates to economic analysis: were the mainstream macroeconomic models used before the crisis appropriate to help guide policy decisions, or should these be changed? Let me start with the first question. The shortcoming of mainstream macroeconomics and of the type of Dynamic Stochastic General Equilibrium DSGE models that prevailed before the crisis, are by now quite well known.

When introducing financial frictions, we have relied on a reduced form representation that is consistent with different theoretical micro-foundations. This more flexible, semi-structural approach allows us to model a wide range of banking and financial variables, going from bank lending spreads to term premia, without taking a stance on the theoretical fundamental debate about how they are linked to the macroeconomy.

A crucial theoretical aspect which requires improvement is related to the Phillips curve, the most commonly used empirical model of inflation that faces several estimation problems as it uses several unobservable variables.

Fiscal and Monetary Policy Actions in the Short Run

In , Phelps and Friedman introduced expectations as a variable that shifted the previously considered stable relationship. Jointly with this change, Friedman added the concept of a fixed Natural Rate of Unemployment NARU , determined only by supply factors, to which the economy would tend in the long-term. The difference between actual unemployment and this long-term unemployment rate became the variable used as proxy for demand pressure in the market of goods and services, seen as the main theoretical cause of inflation.

Inflation was an excess demand phenomenon and demand could be controlled by monetary policy — via monetary aggregates for Friedman or with interest rates, as believed today. Phillips Curve PC model that incorporates long-run neutrality and an explicit role of supply shocks in shifting the Phillips Curve up or down, together with an interpretation of the influence of past inflation as reflecting generalized inertia rather than expected inflation.

Inflation depends on forward-looking expectations, and expectations respond rationally to actual and expected changes in monetary and fiscal policy. This second approach produces what is called the New Keynesian Phillips Curve NKPC that basically focuses on the output gap and expectations and is a crucial part of the DSGE models, where the interest rate is all-powerful to control demand and therefore inflation. Gordon and others forged ahead with the first approach, adding variables representing supply shocks as prices depend on demand and supply factors , inertia represented by long lags of inflation and a time-varying NAIRU determined by a simple stochastic process.

The slope of the PC relationship between inflation and the unemployment gap does not decline by half or more as in the recent literature, but instead is stable. As is to be expected, the value of that coefficient depends on the entire specification of the regression. When it does not use supply-side variables, assumes inflation lags with coefficients that add to 1, and a constant NAIRU, as in the NKPC specified by Roberts, it is natural that the low inflation environment of the period shows up in a declining slope coefficient.

The problem is that the NKPC did not perform empirically well from the start. Many ad-hoc remedies have been tried in order to make it work, even when they did not conform to the pure theoretical paradigm of the model. Many other transformations have been attempted to make variants of the hybrid model perform better. One way is to focus on core inflation on which the missing supply factors may be less important. Another approach is to take expectations from consumer surveys or professional forecasters, which of course are not microfounded.

So, pragmatically adjusted, hybrid NKPCs can be made to work, especially for core inflation. This specification is quite distant from the initial pretensions of the NKPC and from rationale of DSGE models where everything is microfounded and subject to rational expectations. The two strands of the literature identified by Robert Gordon seem to have undertaken some convergence.

Lesson summary: Fiscal and monetary policy actions in the short run (article) | Khan Academy

An important part of the under-prediction of inflation in recent years may be the result of an underestimation of the slack in the economy. This is illustrated by the fact that we better predictions of inflation can be obtained when the broad concept of unemployment is used e. Usual measures of slack can vary substantially across methods and chosen variables, although they tend to agree on the timing of peaks and troughs.

The fact that economic activity is multidimensional suggests that there might be advantages in using large dynamic models to estimate it. One way to discriminate among different estimates of the output gap is to check their ability to forecast inflation.

Reading: Monetary Policy and Aggregate Demand

It turns out that the variants associated with a continuation of a positive growth trend, implying a wider output gap, are the ones that produce better inflation forecasts. This points to the great uncertainty behind the estimation of the output gap, the same being true about the concept of an unemployment gap more directly involving the NAIRU. In any case, what matters is that it is possible to find specifications that can be used as fairly good inflation forecasting tools.

In recent ECB work about understanding the low inflation environment, a variant of the hybrid NKPC for core inflation was used but with the inclusion of import prices, lagged inflation and expectations taken from surveys. This is a source of confidence that our policy, having contributed to the recovery, will in the end contribute to achieve our inflation goal.

Monetary and fiscal policy - Aggregate demand and aggregate supply - Macroeconomics - Khan Academy

Another question related to the PC, beyond the forecast of inflation, refers to the interpretation and use of the NAIRU that can be extracted from it. This view then endorses the use of estimated NAIRUs for several policy decisions: for instance, using that particular value as a measure of structural unemployment that enters into the calculation of potential output and the structural budget deficit with all its implication for fiscal policy.

Trusting just one number to conduct policy can be dangerous. A second aspect to underline is that it is difficult to accept that estimated NAIRUs are long-term constants determined exclusively by supply-side factors.