Fed Chairman Bernanke Chosen as Time Magazine's Person of the Year

In a December 16, 2009 article, Michael Grunwald details the reasoning behind Time Magazine’s choice of Federal Reserve Chairman Ben Bernanke for Person of the Year. The article delves into Bernanke’s background such as his working class roots and the consensus that he is “a leading scholar of the Great Depression.” It also details the unique nature of the crises of 2007-2008 to which the Fed responded in creative and beneficial ways.

Chairman Bernanke is currently awaiting a Senate vote to be confirmed for another term as Fed chairman. The vote is being held up by a Senator from the far left and another from the far right. The Time article is largely critical of those who oppose Bernanke, portraying them as nitpicky demanders of perfection who fail to realize that the Federal Reserve’s actions over the past two years most likely “prevented an economic catastrophe.” It is apparent that the Fed, like most people caught up in benefiting from the bubbles of those years, took too long to recognize the danger signs. Yet, the desire to criticize and rein in the Fed’s power now that the crises are largely history is short-sighted and will be harmful to long-run inflation rates. Most economics textbooks cover the extensive research that shows that greater central bank independence goes along with more stable and lower inflation rates.

As Bernanke is quoted in the article, "We came very, very close to a depression ..." That is because in the fall of 2008, the collapse of the financial sector and asset prices looked remarkably similar to the events that marked the start of the Great Depression. However, thanks largely to the bold actions of Bernanke’s Fed, the US experienced a severe recession rather than a depression. That distinction is significant and reason enough for the awarding of Time Magazine’s honor. Grunwald’s article gives evidence that Bernanke’s knowledge and research into the Depression made him the perfect man to hold one of the most powerful positions for influencing the world economy. As written by Grunwald, “He didn't just reshape U.S. monetary policy; he led an effort to save the world economy.”

Admittedly, the severe recession has caused significant hardship to billions of people. However, based on economists’ consensus definition of recession, the US economy has been in recovery and thus out of recession for several months now. Indeed, the figure to the right shows a picture of an economy that will most likely experience positive net job creation in coming months. Such positive net job creation has not occurred since the recession began in December 2007. This scenario looks much rosier than could have been hoped for back in the fall of 2008. This is an important reason why Bernanke is expected to be confirmed for another term:



Finally, Bernanke’s critics need to understand that macroeconomics is not a true science. Despite the mathematical rigor required to publish articles in the field, macroeconomists cannot perform true experiments with a nation’s economy. Therefore, there is no comparison “control group” of a US economy run by someone who chose not to bailout AIG or who refused to dramatically expand the Federal Reserve’s balance sheet with risky assets. We will never know with any respectable precision what might have happened if it had not been for Bernanke’s bold leadership.

Perhaps someday a scientific genius will invent a time machine so that Bernanke’s critics can go back to the early 1930s to experience a collapsed economy. Most economists agree that the experience of those years is the best counterexample to show what we would have experienced without bold action by the Fed and our elected officials. Let the critics be reminded that the demand for perfection is all too often the enemy of good governance.

Discussion Questions

1. What is your reaction to Time Magazine’s choice of Federal Reserve Chairman Ben Bernanke for Person of the Year? Why?

2. Suppose that you were able to cast a vote in the Senate on Bernanke’s reappointment. How would you vote? Why?

3. Imagine you were currently chairperson of the Fed. What, if anything, would you be doing differently?

4. Do you approve or disapprove of the movement to rein in the power of the Federal Reserve? Explain.

The Federal Reserve’s New Target Range

On December 16, 2008, one of the most significant monetary policy decisions in US history was handed down by the Federal Reserve's Open Market Committee (FOMC). In an effort to combat accelerating deflation in the Consumer Price Index (CPI) and massive job losses, the FOMC announced a reduction of its federal funds rate target from 1% to an unprecedented range of 0% to 0.25%. While critics of the move might point to relatively stable core inflation rates (which exclude food and energy), the FOMC was clearly more concerned about the state of the job market and the accelerating deflation reflected in the headline CPI. In fact, for two consecutive months, the US experienced record CPI deflation with rates of -1% in October and -1.7% in November of 2008. Along with OPEC's attempts to curtail oil production, this move by the FOMC is likely to help stabilize the price level.

The Fed announcement is historic for the low level of rates in its targeting and for the unique setting of a target range. This gives the Fed modest room for flexibility above the nominal floor of a zero federal funds rate. Whether it will be enough to spur the feeble economy is doubtful. Fortunately, the FOMC also announced that the federal funds rate is likely to remain within the target range for an extended period. The central bank is also prepared to purchase agency debt and mortgage-backed securities. Furthermore, through the Fed's expanded toolkit, it will begin direct loans to households and small businesses starting in 2009.

Fed chairman Ben Bernanke recognizes that the US economy is ripe for implementing the tenets of his Bernanke Doctrine, outlined in his 2002 speech titled "Deflation: Making Sure 'It' Doesn't Happen Here." In that speech, well before he was appointed to chair the Fed, he stated, "the economic effects of a deflationary episode, for the most part, are similar to those of any other sharp decline in aggregate spending—namely, recession, rising unemployment, and financial stress." Bernanke now has the chance to run the Fed during the precise scenario that he described six years ago.

In fact, the FOMC's press release of December 16, 2008 announces policy that effectively implements most of the seven steps of the Bernanke Doctrine. The FOMC's bold move may stave off a severe recession, but it does not come without potential costs. The combination of aggressive monetary policy, and recent and proposed fiscal stimulus could eventually reduce confidence in the US Treasury's ability to service its debts.

For the time being, Chairman Bernanke appears to be doing what is necessary to support another of his statements from six years ago:

Let me end my talk by abusing slightly my status as an official representative of the Federal Reserve System. I would like to say to Milton and Anna [Friedman]: Regarding the Great Depression. You're right, we did it. We're very sorry. But thanks to you, we won't do it again.

Discussion Questions

1. What could be the negative ramifications of implementing such a bold expansionary monetary policy at this time? How likely do you think it is that such negative ramifications occur?

2. Do you believe that historically low interest rates will be sufficient to save businesses struggling to avoid bankruptcy, such as those in the auto industry?

3. The current state of the US economy bears remarkable similarity to that of the beginning of the Great Depression. Do you think that Chairman Bernanke and his doctrine will keep the US out of a deflationary spiral? Will the doctrine, along with fiscal policy from recently elected officials, be enough to keep America out of a depression?

4. The US national debt held by the public is currently about $6.4 trillion or 45% of the nominal GDP in 2008. Is there any reason to worry over the ability of the US Treasury to meet national debt obligations? Why or why not?

5. Now that gasoline prices have returned to low levels, some economists may believe that it is an appropriate time to raise the federal gasoline tax. Do you agree with this position? Why or why not?

Should We Be Worried About Deflation?

We're used to low and stable inflation in the United States—a slow, but steady increase in the prices of goods and services over time. The inflation rate measures the pace at which prices rise over time. The table below shows the CPI (consumer price index)—which measures the average price of a representative basket of consumer goods and services—from July to October in 2007 and 2008, as well as the annual inflation rate. In recent months, the U.S. economy experienced disinflation—the annual inflation rate, while positive, declined from a peak of 5.6% in July to 3.7% in October. The CPI continues to rise year-on-year, but it's doing so at a slower and slower pace.

Notice that the CPI declined significantly in October 2008 (from 218.8 in Sep '08 to 216.6 in Oct '08). In fact, the 1% decrease in consumer prices during October 2008 was the largest one month decline in 61 years. The sharp month-on-month decline in prices raised some fear of deflation. Deflation occurs when the prices of goods and services fall over time. Persistent deflation leads to negative annual inflation rates.



A sharp reduction in total spending by businesses and consumers typically precedes an overall drop in prices. For deflation to persist, business and consumer expectations must adjust. If people expect prices to continue falling, they will postpone purchases. Why buy today what can be obtained more cheaply tomorrow? The postponed spending reduces the current demand for goods and services. With weaker demand, prices fall even further and firms begin to cut back on production and lay off workers. Should we be concerned about this type of deflationary spiral?

Exploring the difference between headline and core inflation can help us answer this question. Headline inflation, reported in the table above, measures changes in all consumer prices. Core inflation measures changes in the CPI excluding food and energy prices. Since food and energy prices tend to be volatile compared to other prices, removing them from the CPI can allow economists to obtain a less distorted view of the inflation trend. The core inflation picture for October 2008 is far less alarming—the CPI less food and energy prices barely registered a change.

Falling energy prices were the primary cause of headline deflation in the month of October. A decrease in the relative price of energy is not necessarily a bad thing. A good's relative price is measured in physical units. Suppose that, in May 2008, the price of gas was $4 per gallon and the price of a movie ticket was $8. To express the relative price of gas in May 2008, we'd say that one gallon of gas cost one-half of a movie ticket. If, in October 2008, gas is down to $2 per gallon but movie tickets still cost $8, we'd say that the relative price of gas is one-quarter of a movie ticket. In other words, gas has become relatively cheaper since energy prices are falling as other prices remain largely the same.

Nobody's complaining about relatively inexpensive gas. Declining energy prices will likely feed through to the prices of other goods and services in the coming months. We may even see a negative year-on-year inflation rate. But a damaging deflationary spiral still seems like a remote possibility. Only when consumers and businesses begin to build expectations of falling prices into their decisions will deflation become a real threat.

Discussion Questions

1. Deflation presents big problems for debtors. Recall that the real interest rate a borrow pays on a loan is equal to the nominal interest rate minus the inflation rate. If you take out a fixed rate loan with a nominal rate of 8% and expected inflation of 2%, you'd expect to pay a real rate of 6%. What happens to your real rate if falling prices push the actual inflation rate to -1%?

2. What would deflation do to the purchasing power of a debtor's principal balance? For instance, how would persistent deflation affect people's ability to repay home loans? How would it affect the already beleaguered housing market?

3. If the Fed fears persistent deflation, what policies should it pursue to ensure that deflationary expectations do not develop? What are the risks associated with anti-deflationary monetary policy? How could government fiscal policy assist the Fed in preventing deflation?

America's Looming Liquidity Trap

In October 2008, the US unemployment rate hit 6.5%, a 14-and-a-half year high, as announced by the Labor Department. This lofty rate is likely to increase in the coming months in the wake of the ongoing financial crisis and adjustments in the real estate market. It also comes despite two 50 basis point cuts in the target federal funds rate made by the Federal Reserve during that month. These interest rate reductions brought the target fed funds rate down to 1%, a very low target rate by historical standards and close to the nominal rate floor of 0%. The Federal Reserve therefore finds itself in the thorny situation of having only 100 basis points left to work with for possible target rate cuts. (Note that a basis point represents 1/100th of a percentage point, so 1% is 100 basis points.)

The fed funds rate cannot go below 0% because a transaction at a negative nominal rate implies a negative nominal cost of borrowing funds. Furthermore, that implies a positive nominal payoff to the borrower and a positive nominal loss to the lender. Under typical, positive rates of inflation, the real costs and payoffs are amplified. This is shown in the following Fisher equation where i is the nominal interest rate, r is the real interest rate, and is the inflation rate:


This floor for the nominal fed funds rate brings up the very real possibility that the US will soon be mired in a liquidity trap—a situation in which "the monetary authority is unable to stimulate the economy with traditional monetary policy tools." One explanation for this weakness of monetary policy comes from the analysis on the real interest rate given above. In difficult economic times, why would financial institutions take on the risk of lending out money to a borrower who may default on the loan when the real return on even a fully repaid loan is negative!

An excellent source on how our nation might remedy its liquidity trap is given by the 2008 Nobel Laureate in Economic Sciences, Paul Krugman. His 1999 article "Thinking About the Liquidity Trap" offered policy solutions for springing the Japanese economy from the type of liquidity trap that now threatens the United States. Krugman's figure 1 from that paper shows a nice IS-LM example of the ineffectiveness of monetary policy. Wikipedia provides a good introduction to the IS-LM model. Below I present a modified version of Krugman's figure 1, in the context of current US interest rates, to represent traditional monetary expansion with a looming liquidity trap.



An economy may also happen to face declining consumption expenditures, as the US currently does, due to concerns about a rising unemployment rate, which can result in lower exogenous consumption and a falling marginal propensity to consume. In that case, the resulting leftward movements of the IS curve make monetary policy even less effective. Krugman's solution to the scenario is to have the monetary authorities credibly commit to sustained higher future inflation. The expectation that such higher inflation will eat away at the purchasing power of cash holdings should convince consumers to ramp up their spending and move the IS curve rightward.

President-elect Obama and the new Congress will undoubtedly undertake expansionary fiscal policy to attempt to move the IS curve rightward. However, our already massive national debt and the likelihood of waste involved in government spending, support Krugman's solution. Our newly elected officials and the Federal Reserve Board are facing unenviable policy choices.

Discussion Questions

1. Suppose that you were in control of US fiscal and monetary policy. What policies, if any, would you implement to improve US economic conditions?

2. Do you believe that America will soon face a liquidity trap? Why or why not?

3. The International Monetary Fund forecasts that the world's rich economies will collectively experience economic contraction for the first time since World War II. When was the last time America faced a liquidity trap? What circumstances led to that liquidity trap environment?

The Federal Reserve's Expanding Toolkit

On October 8 and 9, major central banks in Europe, the Americas, and Asia took the exceptional step of reducing interest rates in concert to stave off a global economic slowdown during the ongoing financial crisis.

The financial crisis is rooted in the faltering U.S. housing market. Many banks and financial institutions hold assets (such as mortgage-backed securities) that are tied to home loans. As house prices fall and more Americans have trouble paying their mortgages, these assets lose value, and financial institutions find their holdings are worth far less than expected. Such losses hamper the ability of financial institutions to borrow and lend. At the moment, financial institutions are very reluctant to lend to one another for fear of further exposing themselves to mortgage-related losses.

To combat this crisis of confidence, the Fed is dramatically expanding its role as the lender of last resort in the U.S. financial system. In addition to the coordinated rate cut, the Fed's new policy measures include direct loans to insurers and businesses, as well as an unusual level of cooperation with the U.S. Treasury Department. National Public Radio's Laura Conway catalogues the Fed's expanding monetary policy toolkit here.

Discussion Questions

1. Historically, the Fed's status as lender of last resort extended only to commercial banks. How has the scope of the Fed's lending changed as a result of the crisis?

2. Why don't central banks coordinate monetary policy more often?

3. If effective, how will the Treasury's $700 billion rescue package help the Fed's efforts to restore confidence among banks and financial institutions?

4. What constraints do central banks face in responding to the financial crisis?

Paul Romer on the Financial Crisis

Aplia's founder, Paul Romer, recently wrote about the financial crisis on the Growth Blog. In his essay, Romer encourages a more open dialogue between the academics who build economic models and the policymakers who respond to unforeseen economic crises in real time. Read the post to find out more.

Discussion Questions
1. Think about the basic models you learned in introductory economics, like supply and demand. How do these models inform your understanding of the financial crisis? What aspects of the crisis do they leave unexplained?

2. How would you rate the performance of the Treasury and the Fed in handling the ongoing crisis? What would you do differently? How can we prevent similar crises from developing in the future?

Creating Money (or Jobs) Out of Thin Air

Today, amid foreign financial market volatility, the Federal Reserve cut the federal funds rate from 4.25% to 3.5% to prevent a recession. You may read the official press release here. The move is rare for two reasons. The Federal Reserve reduced the federal funds rate before its regularly scheduled meeting next week, and the Federal Reserve reduced the rate by 75 basis points, as opposed to its usual 25 or 50 basis point increments. In summary, today’s move is rare for its timing and magnitude.

The federal funds rate, or the interest rate that U.S. banks charge each other for overnight loans, is the benchmark rate for many short-term and long-term interest rates in the United States. A reduction in the federal funds rate, often times (though not always), decreases the interest rate on credit cards, automobile loans, and mortgages. Lower interest rates encourage consumers to spend and businesses to build new offices and purchase computers, machinery, and software. A boost in consumption (e.g. buying new clothes) and investment (e.g. building new offices) spending are exactly what the economy needs when it is slipping into a recession caused by sudden drops in overall spending. Though the U.S. economy is NOT officially in a recession, the Federal Reserve forecasts “slowed growth” and would like to cut rates just-in-case.

The previous explanation shows how the Federal Reserve could use monetary policy to minimize the depth and length of a recession. However, what is less well known is the process with which the Federal Reserve is able to manipulate the federal funds rate. Essentially, the Federal Reserve lowers the federal funds rate by expanding the money supply. This is easier said than done.

First and foremost, the Federal Reserve does NOT print new dollar bills. So how is it able to create new money? There are two main forms of money—cash in circulation and checking deposits held in banks. Separate from the money supply are “reserve accounts” that commercial banks are required to have at the Federal Reserve. These reserve accounts hold cash for the commercial banks in case depositors cash-out some of their deposits.

The Federal Reserve can expand the money supply by expanding the amount of deposits held in the U.S. commercial banking system. One way to do so is to purchase U.S. government bonds issued by the U.S. Treasury department. When the Federal Reserve purchases government bonds from commercial banks, it takes bonds out of circulation and electronically credits reserve accounts. U.S. commercial banks armed with more cash reserves will issue new loans which are then deposited back into the banking system. This method effectively increases the dollar amount of checking deposits in the economy, and hence, expands the money supply.

Discussion Questions

1. Suppose U.S. commercial banks are highly reluctant to issue new loans even if they are armed with more reserves. How would this impact the Federal Reserve’s ability to expand the money supply and lower the federal funds rate?

2. Republican presidential candidate, Ron Paul, believes that the Federal Reserve “debases and depreciates” the currency through its manipulation of the money supply. In fact, he wants to abolish the Federal Reserve altogether. Using the definition of the money supply and the relationship between interest rates and unemployment, how could the money supply be “pro-cyclical” without the Federal Reserve?

What's a Fiscal Authority to Do?

The likelihood of slow growth or a recession in the United States has policymakers looking for ways to soften the blow. There are two basic ways the government can stabilize output: monetary policy (changes in the money supply and interest rates) or fiscal policy (changes in government taxation and spending). The U.S. monetary authority, the Federal Reserve (or Fed), responded to the threat of recession by lowering interest rates. Lower interest rates reduce the cost of borrowing, accommodating investment and consumption spending during downturns (with the added benefit of lowering the value of the dollar and thus boosting U.S. exports). The timing and magnitude of interest-rate changes are always tricky, but even if rate cuts don't avert a downturn altogether, they'll almost certainly reduce the depth and length of a recession.

But what, if anything, can the fiscal authority—Congress and the President—do to assist the economy? According to Fed chair Ben Bernanke, "Fiscal action could be helpful in principle, as fiscal and monetary stimulus together may provide broader support for the economy than monetary actions alone." (Read this New York Times article for more.) However, Bernanke is hedging a bit here. By saying that tax cuts or spending increases "could be helpful in principle," he implicitly acknowledges that such measures may be ineffective, or even harmful, in practice. The process of agreeing on and passing legislation limits the usefulness of fiscal policy for stabilizing mild fluctuations in economic output. By the time our representatives haggle over and pass legislation, the downturn may be over or the resulting policy may reflect political rather than economic considerations. For this reason and others, recent commentaries by Greg Mankiw and Robert J. Samuelson argue that we should leave the Fed to address mild ups and downs in the business cycle, reserving fiscal policy for deep or prolonged recessions.

Discussion Questions

1. Limitations of fiscal policy aside, Bernanke seems to understand that politicians seeking a track record to run on will often favor policy action over informed inaction. What advice does he give policymakers who are eager to implement fiscal policy?

2. Three specific types of "lag" may delay the beneficial effects of economic policies. The recognition lag is the time it takes us to figure out we're in an economic pickle. We often don't know that we're in a recession until months after it's started. The implementation lag is the time it takes policymakers to agree on and implement policies. The impact lag is the time it takes a policy to work its way through the economy and affect economic output and unemployment. For example, an increase in government spending on highway construction will show up as additional output over the entire life of the project, not all at once. How might these lag times differ between monetary and fiscal policy?

3. Plotting economic output over time reveals two basic observations: the smooth upward trend in output growth over the long haul, and the up-and-down wiggle of output in the short term. To paraphrase Aplia's founder Paul Romer, it's easy to lose sight of the trend for the wiggle. Policymakers can get so wrapped up in temporary economic tumults that they lose focus on the bigger picture. If we're headed for recession, odds are that it will be mild by historical standards and the Fed will have plenty of policy ammunition to soften its adverse effects. Meanwhile, small changes in the long-run rate of economic growth have large impacts on future living standards. Given that, what policies would you recommend the action-minded fiscal authority focus on to improve the long-term growth prospects of the U.S. economy?

For more on the appropriate role of fiscal policy, listen to Bloomberg’s interview with Stanford economist John Taylor.

The Phillips Curve and the Federal Reserve

The Phillips Curve is a concept often covered in introductory macroeconomics. However, in some economic and political circles, the concept is considered outdated and useless. Some economists and commentators, such as Lawrence Kudlow, might go as far as to say that the Phillips Curve is dead. Why does the Phillips Curve command such controversy? Is it as irrelevant as some economists claim?

The traditional Phillips Curve is the trade-off between the inflation rate and the unemployment rate. Many economists in the 1960s thought that the Federal Reserve or Congress could permanently lower the unemployment rate by increasing the inflation rate. The trouble is, the traditional Phillips Curve violates one of the central tenets of economics: the classical dichotomy. According to the classical dichotomy, nominal variables do not affect real variables. Consider a simple example:

I hold a bag of apples that weighs 5 pounds. The weight (i.e., the force exerted on my arm) is a real variable and the unit of measurement (i.e., pounds) is a nominal variable. Suppose the U.S. government passes a new law that says all measurements must conform to the metric system. Now the same bag of apples weighs 2.27 kilograms. Notice that the nominal variable (how the weight is measured) has absolutely no effect on the real variable (the force exerted on my arm).

The traditional Phillips Curve is in direct contradiction of the classical dichotomy. The Phillips Curve implied that the government could effectively reduce the unemployment rate (a real variable) by changing how fast overall prices are growing in the economy (a nominal variable). Though the traditional Phillips Curve held up well in the 1960s, the 1970s would usher in the downfall of the traditional Phillips Curve.

In the 1970s, the trade-off between the unemployment rate and the inflation rate seemed to fall apart. The United States experienced soaring overall prices and rising unemployment. In other words, there appeared to be an upward-sloping relationship between the inflation rate and unemployment rate. Due to this fact, many economists declared the Phillips Curve to be dead.

Due to the abrupt change in the correlation between inflation and unemployment, several theories were proposed as alternatives to the Phillips Curve. These theories include the Real Business Cycle (RBC), Rational Expectations, and Monetarism. Often times these theories are called “New Classical” economics because they promote the classical dichotomy.

Under heavy pressure from competing theories and empirical evidence, a new school of thought known as “New Keynesian” economics sought microeconomic foundations for the Phillips Curve. Edmund Phelps, the Nobel Laureate in 2006, augmented the traditional Phillips Curve by adding the critical role of expectations. Under the expectations-augmented Phillips Curve model, a trade-off between inflation and unemployment does exist but only in the short run. According to the model, inflation expectations adjust to return the economy to its natural rate of unemployment (i.e., an unemployment rate consistent with non-accelerating inflation). George Akerlof, the Nobel Laureate in 2001, provided behavioral explanations for the trade-off. Subsequent works by economists, such as David Romer and Greg Mankiw, provided additional microeconomic foundations for a short-run trade-off.

Through all the intellectual turmoil, most economists agree on the following:

1. There is a short-run trade-off between the inflation rate and the unemployment rate.
2. In the long run, the inflation rate adjusts to restore the natural rate of unemployment. Hence, policy makers cannot permanently push unemployment below its natural rate by permanently increasing the inflation rate.

How well does the modern Phillips Curve describe the real world, and do practitioners actually use the modern Phillips Curve? James Stock and Mark Watson, authors of a famous introductory econometrics textbook and well-respected econometricians, empirically showed that the modern Phillips Curve bested all other alternatives in terms of forecasting inflation. Ben Bernanke, chairperson of the Federal Reserve, professed publicly here and here on the importance of the modern Phillips Curve in the Fed's inflation forecasts, which ultimately influence monetary policy.

The Phillips Curve has changed over the past 40 years, but it is very much alive as a reference for monetary policymakers.

Discussion Questions:

1. Go to the Bureau of Labor Statistics web site and pull data on the national unemployment rate and the CPI inflation rate. For your convenience, I have included the spreadsheet here. Does there appear to be a trade-off between inflation and unemployment between January 2001 and December 2001?

2. Does there appear to be a trade-off between January 1997 and October 2007?

3. Why do you think an increase in the inflation rate decreases the unemployment rate in the short run? Why do you think a decrease in the unemployment rate increases the inflation rate in the short run?

Inflation Targeting Lite

A central bank controls the economy's money supply—the growth of which ultimately determines the growth of the economy's price level (the inflation rate). Many of the world's central banks publicly announce inflation targets. An inflation target is a specific rate (such as 2%) or a range of inflation rates (such as 1%–3%) that the central bank will try to achieve over time. By publicly announcing and consistently hitting an inflation target, these central banks hope to enhance their credibility and anchor people's expectations of future inflation. If people believe a central bank's commitment to low and stable inflation to be credible, they will expect future inflation to be low and stable—feeding a virtuous cycle of low inflation, low inflation expectations, and slow increases in overall prices and nominal wages. Confidence that inflation will remain low reduces the uncertainty surrounding saving and investment decisions, fostering a favorable climate for economic growth.

The Federal Reserve System (the Fed) is a notable holdout on inflation targeting. Most people understand that one of the Fed's policy mandates is price stability, or low and stable inflation, but the Fed has never publicly described exactly what "low and stable inflation" means. Fed chairman Ben Bernanke recently announced a change in Fed practices that will move U.S. monetary policy a bit closer to the inflation targeting ways of the rest of the world. The Fed will now publish three-year economic forecasts four times per year (rather than two). More importantly, the Fed will tell us how it thinks economic output, unemployment, and inflation will take shape over the next few years based on its application of monetary policy. The Fed will essentially say, "Here's what we expect inflation to be if we implement sensible monetary policies over the next three years."

That's not quite the same as explicitly stating a target, but it sounds pretty similar. The American public will now have a better sense of the inflation rate that the Fed seeks to restore in the event of economic disturbances that move the inflation rate away from the Fed's projection. Read this New York Times article or Bernanke's speech to learn more about the Fed's efforts to increase transparency.

Discussion Questions

1. Many central banks face a sole mandate of price stability, whereas the Fed faces a dual mandate of price stability and full employment. Over which part of its dual mandate does the Fed exercise more influence, price stability or full employment?

2. Chairman Bernanke, an advocate of inflation targeting, mentions in his speech that "a superficial drawback of inflation targeting is its very name, which suggests a single-minded focus on inflation to the exclusion of other goals." He goes on to point out that most central banks practice flexible inflation targeting that allows them to focus on other policy goals. The former chairman of the Federal Reserve, Alan Greenspan, was generally opposed to inflation targeting. As the Times article points out, Greenspan felt that "explicit public commitments would hobble the Fed's ability to respond nimbly to unexpected developments." Do you think a publicly announced inflation target would help or hamstring the Fed's dual mandate?

3. Monetary policy has become more transparent over the past couple of decades. The Fed's latest move to publicly offer more frequent and in-depth economic analysis is a continuation of this trend. How will the additional information help households and firms make economic decisions and plan for the future? How can monetary policy become more transparent over time? Should it? For example, would televised meetings of the Federal Open Market Committee (FOMC, the Fed's policymaking arm) help firms and households to make better saving and investment decisions?

Monetary Policy Reaction Function

The recent financial turmoil and its economic consequences have led the Federal Reserve to aggressively cut the federal funds rate, a key benchmark for all interest rates. In a previous blog post, I explained how the Fed could keep the federal funds rate constant while money demand increases. Now I want to focus on how and why the Federal Reserve reduces the federal funds rate.

The "how" question is easily answered in most economics textbooks. Once the Federal Open Market Committee (FOMC) decides to cut the federal funds rate by 50 basis points, the Open Market Trading Desk purchases the quantity of government securities necessary to reach the new federal funds rate. The graph on the right shows how open-market purchases could lower the federal funds rate from 5.25% to 4.75%.

So far, I have stuck to the facts without building a model of the Fed's behavior. Economists sometimes find it convenient to model the behavior of the Fed in terms of a monetary policy reaction function (MPRF). The following is an example of an MPRF from Ben Bernanke and Robert Frank's Principles of Economics:

Of course, the MPRF above is just one example, and there are other examples (such as the Taylor Rule) that are more complex. For teaching purposes, let's just use the simple MPRF.

In addition to equations, economists often use graphs to depict models. The following graph shows the simple MPRF with the real interest rate on the Y-axis and the inflation rate on the X-axis. Assume a 3% actual and long-run target inflation rate.

The graph shows that a downward shift in the MPRF reduces the actual real interest rate from 2.25% to 1.75% when the actual inflation rate is equal to the initial target inflation rate of 3%. Assuming that the actual inflation rate remains constant in the short run, the shift in the MPRF causes a reduction in the real interest rate, and consequently stimulates investment and consumption. The ultimate goal is to stimulate aggregate demand and prevent the recent financial turmoil from drastically affecting the broader economy.

Discussion Questions

1. Refer to the simple MPRF equation. A downward shift of the MPRF could be accomplished by a reduction in the long-run target real interest rate (r*). The Fed typically sets r* in line with the equilibrium real interest rate that prevails in the market for loanable funds. Is there reason to believe that the recent financial turbulence has disrupted investment, private saving, public saving, or net capital inflows?

2. A downward shift of the MPRF could also be accomplished by an increase in the long-run target inflation rate. Is there reason to believe that the Fed has increased the long-run target inflation rate?

3. Are there other factors that the Fed should consider in its MPRF?

Monetary Policy and Flexible Exchange Rates

The Federal Open Market Committee (FOMC), the monetary policy arm of the Federal Reserve, announced a 50-basis-point reduction in the target federal funds rate on Tuesday, September 18. The stock market soared in response to the rate cut because most market watchers were only expecting a 25-basis-point reduction. Read the FOMC statement for the reasons behind the rate cut. After the announcement, the U.S. dollar decreased in value against the euro, the British pound, the Japanese yen, and the Canadian dollar. This was no coincidence, and the reduction in the value of the dollar actually reinforces the Federal Reserve's goal of maintaining moderate economic growth.

The federal funds rate is a benchmark for other interest rates in the United States. For simplicity, let's imagine for a moment that the federal funds rate is the only interest rate in the United States. If this is true, then the U.S. interest rate is also the dollar rate of return for holding U.S. assets. However, the United States is not the only country in the world. The European Union has its own interest rate that represents the euro rate of return for holding EU assets. For a given amount of volatility in asset prices, investors place their savings in assets that offer the best rate of return after adjusting for the exchange rate.

A reduction in the U.S. interest rate makes U.S. financial assets relatively less attractive than before because the EU interest rate has remained unchanged. U.S. investors will want to purchase more EU assets (i.e., there will be an increase in the supply of U.S. dollars), and EU investors will want to purchase fewer U.S. assets (i.e., there will be a decrease in the demand for U.S. dollars). Figure 1 shows the subsequent changes in the market for U.S. dollars.

A depreciation of the U.S. currency will make U.S. exports relatively inexpensive for foreigners while making imports from foreign countries relatively expensive for Americans. A decrease in the interest rate causes an increase in net exports and reduces the size of the U.S. trade deficit. Figure 2 shows the relationship between the exchange rate and net exports. Since net exports are a component of total spending in the U.S. economy, the Fed's rate cut provides two boosts to aggregate spending: (1) the rate cut stimulates consumption and investment because the cost of borrowing decreases; and (2) the rate cut stimulates net exports due to U.S. dollar depreciation. By cutting the target fed funds rate, the Fed intends to prop up spending and growth at a time when tightening credit conditions threaten to slow or reverse the growth of economic output.

Discussion Questions

1. The previous analysis assumes that the United States and the European Union operate under a flexible exchange rate regime. Would the Fed be able to maintain moderate output growth after a severe shock, such as the subprime mortgage meltdown, if U.S. dollars were fixed to a currency such as the euro?

2. What if the Fed is wrong about the adverse effects of tightening credit conditions? What if growth would have continued at a moderate pace even without a rate cut? How would the decision to cut rates affect output and inflation in the short run and in the long run?

3. Suppose that at the next FOMC meeting on October 31, 2007, a jump in the inflation rate is reported. What would the FOMC do to the interest rate? How would this affect the exchange rate and net exports?

The Fed's Rate Cut

As Greg Mankiw recently pointed out and Wall Street Journal reporter David Wessel was quick to observe nearly a month ago, the actual federal funds rate has been trading below the Fed's target federal funds rate of 5.25%. The federal funds rate is the rate at which banks borrow from one another overnight, and it is the key benchmark interest rate for monetary policy. The Fed targets a relatively low, or loose, fed funds rate in order to encourage borrowing, speed up economic growth, and avoid recession. The Fed targets a neutral rate when it wants neither slower nor faster growth than the economy is currently experiencing. The Fed targets a relatively high, or tight, rate when it wants to discourage some borrowing, slow the pace of economic growth, and ensure price stability (low and stable inflation).

According to Mankiw, the actual fed funds rate averaged 5.02% during August—23 basis points lower than the target—while in the preceding 13 months, the Fed had never allowed the actual rate to deviate from the target by more than 1 basis point. Although we can't be sure until the next Federal Open Market Committee (FOMC) meeting on Tuesday, September 18, the behavior of the actual rate in August seems to suggest that the Fed will cut the target federal funds rate to at least 5.0%. A rate cut would mean that the Fed is backing away from a tighter policy stance associated with reducing inflation, and moving instead toward a more neutral monetary policy that will allow it to wait and see how the recent subprime and housing-market turmoil plays out in the broader economy.

The prospect of a rate cut raises the issue of moral hazard. Some critics feel that any loosening by the Fed will bail out borrowers who have taken on risky subprime mortgages and investors who have purchased the assets backed by such mortgages. By cutting rates, the Fed may encourage borrowers, lenders, and investors to make similar gambles in the future on the assumption that the Fed will intervene if things turn sour. Tyler Cowen's latest New York Times column argues that while the Fed should not go out of its way to help poor decision makers, the Fed's mandate—price stability and full employment—should not be sacrificed for fear of instigating moral hazard.

Discussion Questions

1. If banks become increasingly reluctant to lend to one another and to individual borrowers, what will happen to the types of consumption and investment expenditures that are typically financed by borrowing?

2. If borrowing difficulties persist for an extended period of time, what would you expect to happen to housing prices? What about economic growth? How should the Fed respond to this type of credit crunch?

3. Consider the borrowers, lenders, and investors who made poor decisions in the subprime market. Will some of them benefit from an FOMC decision to cut rates? Can the Fed prevent all moral hazard associated with monetary policy decisions? Can Fed policy provide total relief to the borrowers, lenders, and investors who made poor decisions in the subprime markets?

Interest Rates and Inflation

The central bank of China has been combating surging inflation, which recorded an 11-year high of 6.5% last month. The inflation has contributed not only to the erosion of purchasing power, but also to negative real interest rates in China. Recall that

Real Interest Rate = Nominal Interest Rate – Inflation Rate

While nominal interest rates are never negative, real interest rates will be negative if the inflation rate exceeds nominal interest rates.

Interest rates play a dual role in the economy. On the one hand, they determine the interest payments banks make to depositors; on the other, they determine the interest payments borrowers make to banks. Since the interest rate is the return on deposits, negative real interest rates imply a loss of purchasing power if people deposit money into banks. This will discourage people from saving and encourage them to withdraw their funds for current consumption and investment.

At the same time, negative real interest rates mean that the cost of borrowing is low or even negative. Because of this, negative real interest rates can boost aggregate demand, or total spending, and fuel a bubble in the stock market. As observed by Dong Zhixin of China Daily, low interest rates have played an important role in fueling the Chinese stock market, with people withdrawing or borrowing from banks to buy stocks.

In August, the People’s Bank of China raised nominal interest rates for the fourth time this year in an effort to cool the economy. This will boost real interest rates and raise the cost of borrowing at any given inflation rate. The higher cost of borrowing will hopefully curb excessive spending and ultimately reduce inflation.

Discussion Questions

1. Is it possible or even desirable for the Chinese government to fine-tune the real interest rate by adjusting the nominal interest rate? Why?

2. China's currency, the yuan, is fixed to the U.S. dollar within a narrow band in the foreign exchange market. What impact do rising interest rates in China have on the exchange rate?

Lender of Last Resort

Rising foreclosures among homeowners with subprime mortgages led to unusually tight credit conditions in the banking system last week. Banks became reluctant to provide routine short-term loans to one another for fear that a borrowing bank's balance sheet would be too heavily concentrated in shaky subprime loans. When banks are reluctant to lend to each other, they tend to make fewer loans to businesses and households. Liquidity—the ease with which banks lend to creditworthy costumers and institutions—began to dry up. On August 17, the Fed entered the fray.

In two press releases (here and here), the Fed acknowledged that recent reluctance to lend posed a threat to economic growth, and in a rare move, it encouraged banks with limited credit access to borrow directly from the Fed by lowering the discount rate. The discount rate is the interest rate at which banks borrow from the Fed. The Fed typically sets the discount rate 100 basis points (1 percentage point) above the rate at which banks lend to one another (the federal funds rate). On August 17, the Fed narrowed the spread between the discount and federal funds rates to 50 basis points—thereby reducing the penalty associated with borrowing from the Fed.

By lowering the discount rate, the Fed was fulfilling its function as the lender of last resort. To see why the Fed stepped in, it helps to consider how subprime fears might affect the availability of loans for creditworthy borrowers. Banks, especially large ones, often borrow in order to meet the Fed's reserve requirement (the fraction of the bank's deposits that must be held in reserve rather than being lent out). Without knowledge of which big banks will be affected by subprime foreclosures, other banks that would typically lend some of their excess reserves to big banks at the federal funds rate will be reluctant to do so. If large banks that are short on required reserves find it difficult to borrow reserves in the federal funds market, they will be forced to call in loans, and they'll be hesitant to make any further loans. If banks call in loans and hesitate to lend to even creditworthy people and businesses, loan-dependent consumption and investment spending will fall, leading to slower economic growth, or worse, recession.

By reducing the discount rate, the Fed hopes to increase liquidity in financial markets by making it easier for banks to obtain short-term loans. If the policy works, creditworthy borrowers will not have any trouble obtaining loans for houses, cars, factory expansions, office buildings, and the like. As the subprime crisis subsides, regular credit conditions should prevail and the Fed will be able to return the spread between the federal funds rate and discount rate to its initial value of 100 basis points. If the credit crisis persists in spite of the discount rate move, the Fed will have to take stronger action. Read a recent Bloomberg column by John Berry to find out more.

Discussion Questions

1. In times of financial crisis, the Fed functions as a lender of last resort. More typically, the Fed's role is one of economic stabilization—maintaining low and stable inflation as well as full-employment output. How does the Fed's discount rate decision help it to fulfill its roles as lender of last resort and economic stabilizer?

2. Berry's column mentions "moral hazard" several times. In what way does the Fed's discount rate decision risk moral hazard?

3. Fears about losses from assets backed by subprime mortgages were at the root of much of the financial turmoil of recent weeks. According to Berry's column, how do the estimated losses from the default of subprime borrowers compare to the total assets of the U.S. and Euro-area banking sectors?

4. If the credit crisis continues and economic growth suffers, how might the Fed respond?

5. According to Berry, "…growth may have been damaged even if [credit] markets do settle down relatively soon." How would a temporary credit crisis damage economic growth? Consider the links between lending, housing prices, household wealth, and consumption, as well as the link between lending and investment.

Central Banks to the Rescue

World financial markets woke up to a rude surprise on the morning of Friday, August 10. The U.S. subprime mortgage debacle, which was originally thought to be well-contained within a small segment of the U.S. mortgage market, had spread to Europe. This was the straw that broke the camel's back, especially after several hedge funds from highly reputable investment companies collapsed due to heavy reliance on mortgage-backed securities. Hearing this news, bondholders and stockholders were quick to sell their risky holdings in exchange for liquidity (also known as money), which is relatively stable in value.

Aside from the fact that a sudden spike in selling activity in financial markets reduces the paper wealth of investors, it could quite possibly reduce real wealth. First, let's examine the money market effects of a sudden bond and stock sell-off due to a rise in risk aversion. For simplicity, we'll assume there are only three forms of financial assets: bonds, stocks, and money. The sell-off raises the demand for money from MD1 to MD2, as shown in the diagram below.

If the central bank does nothing and fixes the money supply at MS1, the equilibrium interest rate increases from 5.25% to 10%. The economy moves from point A to point B.

Second, let's examine the output market effects of a sudden bond and stock sell-off assuming that the central bank keeps the money supply constant. Higher interest rates mean a higher cost of borrowing for households and firms. Since big-ticket items such as automobiles, factories, and machinery are usually debt financed, consumption and investment spending (on physical capital) will decrease. Because consumption and investment spending are the two most important components of aggregate demand, a lack of central bank intervention will lead to a decline in aggregate demand from AD1 to AD2, as shown in the graph below.

If the central bank does nothing and fixes the money supply at MS1, the equilibrium interest rate increases, which reduces aggregate demand and causes a recession in the short run. The economy moves from point A to point B.

Third, let's examine how central banks around the world reacted to the liquidity hoarding. As the New York Times put it, "central banks around the world acted in unison… to calm nervous financial markets by providing an infusion of cash to the system." The Federal Reserve, along with most central banks, believes that fixing the interest rate is a better policy to maintain price stability and full employment. The Fed performed the cash infusion through of a series of government bond purchases known as open-market purchases, which is another term for the purchase of government bonds by the Fed. The cash infusion, or reserve injection, as textbooks call it, shifts the money supply curve from MS1 to MS2. The reserve injection effectively keeps the interest rate constant and avoids a recession.

If the reserve injection fails to calm financial markets and investors continue to hoard liquidity while selling bonds and stocks, central banks could inject additional reserves into the banking system through additional open-market purchases. The amount of money the Fed can create through purchasing government bonds is nearly limitless.

Read the Federal Reserve's actual press release from Friday, August 10, 2007.

Discussion Questions

1. For the most part, the Federal Reserve's main concern is first and foremost inflation, and secondarily unemployment. Given these two goals, should the Federal Reserve intervene every time the stock market takes a plunge?

2. Most economists believe that a permanent increase in the money supply will generate inflation and make the prices of everyday goods and services higher than they are today. Is this scenario likely given the large reserve injections in the U.S. and world money markets? Why or why not?

3. Some economists believe that markets are highly efficient in the sense that prices and interest rates adjust immediately to guarantee full employment. If this were true, would the Fed's reserve injections have any effect on credit markets or the economy as a whole?

A Chinese Dilemma

The People's Bank of China announced on May 18 that it would allow the yuan to float within a 0.5% band around a government-imposed exchange rate. For example, if the government-imposed rate were 7.6938 yuan per U.S. dollar, the central bank would allow the exchange rate to fluctuate between 7.6553 and 7.7323 yuan per U.S. dollar. Due to a soaring economy and a widening trade surplus with the United States, the yuan closed at a record high of 7.6686 yuan per U.S. dollar on the first day of the new exchange rate policy. In other words, after the announcement, the yuan strengthened against the U.S. dollar.

A "stronger yuan" means that 1 yuan can purchase more U.S. dollars than before. If the exchange rate were 1 yuan per U.S. dollar, yuan holders could obtain $1 for each yuan exchanged. If the exchange rate fell to 0.5 yuan per U.S. dollar, yuan holders could obtain $2 for each yuan exchanged. Hence, the yuan gets stronger as its exchange rate falls, and is stronger at 7.6686 than at 7.7323 yuan per U.S. dollar.

The stronger yuan makes Chinese products more expensive for Americans, reducing net exports and therefore lowering China's real GDP growth rate. Why would the People's Bank of China want to destroy jobs in its exports sector by favoring a stronger yuan? One popular explanation is that the Chinese government is giving in to U.S. political pressure to strengthen the yuan. A stronger yuan would reduce the U.S. trade deficit with China, boosting American goodwill towards China and avoiding the passage of U.S. restrictions on Chinese imports.

There is also an economic explanation for China's new exchange rate policy. Along with China's recent double-digit economic growth comes the prospect of high inflation and economic instability. The standard monetary policy remedy for an overheating economy is higher interest rates. Raising the cost of borrowing reduces overzealous consumption and runaway investment spending. Furthermore, higher interest rates attract more foreign investors, raising foreign demand for Chinese currency, which strengthens the value of the yuan. At the same time, higher interest rates encourage Chinese investors to keep more of their yuan in Chinese assets, leading to a reduction in the supply of yuan, which adds additional upward pressure on the value of the yuan.

Therefore, the People's Bank of China faces an economic dilemma. If it wants to tame the roaring economy, it must allow the yuan to strengthen. But if it wants to maintain a fixed exchange rate, it would need to keep the interest rate unchanged. Today, the central bank has chosen economic stability over exchange rate stability.

Discussion Questions

1. The central bank coupled the exchange rate announcement with a Q&A document for the public. In what ways is the central bank's explanation for widening the exchange rate band similar to our analysis? In what ways is it different?

2. Why would the central bank hesitate to allow the yuan to float freely? In other words, what are the drawbacks of immediately eliminating exchange rate controls?

3. For some time, U.S. policymakers have complained about China's exchange rate policy. How would a weaker U.S. dollar affect American consumers of Chinese products? How would a weaker dollar affect American producers who compete with Chinese producers? How would a weaker dollar affect Chinese consumers of American products and American firms that export goods to China?

Inflation Gone Wild

With an annual inflation rate of 1,600%, Zimbabwe currently holds the world title for fastest-increasing prices. As the late Milton Friedman put it, “Inflation is always and everywhere a monetary phenomenon. To control inflation, you need to control the money supply.” The inflation cure seems simple to understand from a textbook perspective: drastically cut back the money supply in order to lower the expected inflation rate.

Unfortunately, the cure might be worse than the disease. With the current unemployment rate at 80%, drastic cuts in the money supply could increase unemployment and cause a coup d'état before the expected inflation rate falls. The monetary contraction is inevitable if Zimbabwe wishes to tame the inflation monster, and the International Monetary Fund has urged the government to liberalize its exchange rate regime as a means to cushion the unemployment effects.

In order to understand the IMF’s position on Zimbabwe’s exchange rate, we must examine how maintaining an overvalued currency might contribute to soaring inflation, and how floating the currency might provide relief to both inflation and unemployment.

The graph on the left shows the market for Zimbabwean dollars. Assume that the government fixes the exchange rate at E1. A fixed exchange rate is the official value of the currency despite fluctuations in supply and demand. Initially, the official value equals the market value where D1 intersects S1 (point A). Then, due to unsustainable fiscal deficits and government land reforms that usurp private property, foreign investors flee Zimbabwe. Consequently, the demand for Zimbabwean dollars decreases from D1 to D2.

If Zimbabwe were under a floating exchange rate regime, the fall in demand for Zimbabwean dollars would result in the depreciation of the currency from E1 to E2 (point B). But because Zimbabwe’s government insists on a fixed exchange rate regime, the fall in demand for Zimbabwean dollars will cause a surplus of Zimbabwean dollars (Q1 - Q2). At point C, the currency is considered overvalued because the official value is greater than the market value. In order to eliminate downward pressures on the currency, Zimbabwe will instruct its central bank to buy the surplus of Zimbabwean dollars (and sell U.S. dollars), which will return the market to point A. Zimbabwe's central bank will eventually deplete its U.S. dollar reserves as the economy deteriorates from questionable domestic policies, and will borrow U.S. dollars in order to maintain the fixed exchange rate.

Since the loans are denominated in U.S. dollars, Zimbabwe must make periodic payments in U.S. dollars or face getting cut off from all sources of international capital. Due to disastrous domestic policies, the government has little tax revenue to make those periodic payments, and the only way to service their international debts is to print more money, just as Germany did after World War I. As the central bank expands the money supply to pay international debts, inflation increases, which places additional downward pressure on the Zimbabwean dollar: as foreigners demand less and less of the failing currency, Zimbabwe has to print more and more money, and sooner or later, everything will spin out of control.

One solution is to eliminate the fixed exchange rate regime altogether and allow the Zimbabwean dollar to float freely. If the currency were allowed to float today, its value would fall tremendously, which would stimulate exports and reduce imports. The graph on the right shows that as the exchange rate falls from E1 to E2, net exports increase from NX1 to NX2. A floating exchange rate would boost job creation as the central bank institutes the tough medicine of curing inflation by drastically reducing the money supply.

Discussion Questions

1. If the fixed exchange rate regime were eliminated, what would happen to the size of Zimbabwe's international debts in terms of Zimbabwean dollars? Would it increase or decrease?

2. The central bank has recently declared inflation illegal. How do price controls affect domestic markets like those for corn, wheat, electricity, and labor?

3. This analysis assumes that Zimbabwe's reduction in real GDP is due to domestic policies such as unsustainable fiscal deficits and poor private property rights. How might hyperinflation directly contribute to higher unemployment?

Nobel Prize in Economics

The Royal Swedish Academy of Sciences awarded the 2006 Nobel Prize in Economics to Edmund S. Phelps. His work on the expectations-augmented Phillips Curve revolutionized the way economists and policymakers view the relationship between inflation and unemployment.

Most economists in the 1960s believed that there was a permanent trade-off between inflation and unemployment, and they referred to this relationship as the Phillips Curve. The Phillips Curve made policymakers' jobs very easy. If unemployment was too high, then Congress could increase spending and the Federal Reserve could print more money. Higher spending and a larger money supply would raise the inflation rate and bring down the unemployment rate. Hence, the purpose of fiscal and monetary policy was to pick the optimal rate for inflation and unemployment.

Phelps's work suggested that the perceived trade-off between unemployment and inflation was only temporary. It also suggested that there would always be some unemployment--the natural rate of unemployment--due to frictions in the labor market. In the long run, Phelps argued, the trade-off between unemployment and inflation disappears--the unemployment rate returns to its natural rate, regardless of the inflation rate. Hence, the modern purpose of fiscal and monetary policy is to pick the optimal path for inflation and unemployment.

The following is a mathematical interpretation of the expectations-augmented Phillips Curve.

Actual Inflation Rate = Expected Inflation Rate + Constant x (Actual Unemployment Rate – Natural Rate of Unemployment)

The actual inflation rate is dependent on two factors: the expected inflation rate and the unemployment gap (the difference between the actual unemployment rate and the natural rate of unemployment).

During the 1960s, economists observed a nice, smooth downward-sloping relationship between the inflation rate and the unemployment rate because expected inflation was constant. However, soon after the 1960s, expected inflation began to converge with the actual inflation rate (the short-run Phillips Curve shifted to the right). We no longer observe a smooth downward-sloping relationship when the expected inflation rate changes.

Phelps argued that in the long run, expected inflation equals actual inflation. Now, let’s look back at the equation. If actual inflation equals expected inflation, then the unemployment rate must equal the natural rate of unemployment.

Therefore, in the long run, Congress and the Fed cannot affect unemployment through spending or printing more money.

1. Some economists have argued that the natural rate of unemployment increased in the 1970s, which led to misguided monetary policy. Use the short-run and long-run Phillips curves to show how a Fed that believes that there is a permanent trade-off between inflation and unemployment would inadvertently increase inflation without affecting the long-run unemployment rate.

2. Why is it important that the Fed targets an inflation rate rather than an unemployment rate?

How to Cure Inflation

Argentina is no stranger to inflation and has suffered frequent periods of devastating inflation since 1945. Despite recent praise from the International Monetary Fund for its economic growth, Argentina currently suffers from a 12.3% inflation rate (compared to only 4% in the United States).

Milton Friedman, winner of the 1976 Nobel Prize in Economics, compares inflation to alcoholism in his PBS series, Free to Choose:

Inflation is just like alcoholism, in both cases, when you start drinking or when you start printing too much money. The good effects come first; the bad effects only come later. That's why, in both cases, there is a strong temptation to overdo it, to drink too much and to print too much money. When it comes to the cure, it's the other way around, when you stop drinking or when you stop printing money the bad effects come first and the good effects only come later. That's why it's so hard to persist with the cure.

Source: Free to Choose, Volume 9 of 10, How to Cure Inflation (26:40)

A simple aggregate demand (AD) and aggregate supply (AS) diagram offers great insight into Friedman's analogy and Argentina's inflation woes. The following AD-AS diagram is based on a paper by Professor David Romer. The model might be slightly different from the AD-AS diagram in your textbook.

First, let's look at the assumptions in the model. The aggregate demand curve (AD) assumes that the central bank raises the interest rate in order to combat inflation. For example, if the inflation rate increases, then the central bank will raise the interest rate to reduce consumption and investment, thereby lowering output. The short-run aggregate supply curve (SRAS) represents the inflation rate. The long-run aggregate supply curve represents the output level where the inflation rate has no tendency to change. The long-run aggregate supply curve is often referred to as potential output or full-employment output.

Second, let's look at the short-run effects of an increase in the money supply. In the short run, economists assume that the inflation rate is temporarily fixed. The short run might be a period of 1 day, 1 month, or 1 year. There is no consensus about how long the short run lasts. If the central bank expands the money supply, then the interest rate falls. A fall in the interest rate stimulates consumption and investment spending which shifts the aggregate demand curve to the right from AD1 to AD2.The good effects come first--in the short run, it seems as though the economy has benefited from a higher quantity of money. Output increased from $450 billion to $500 billion which creates more jobs without increasing inflation.

Third, let's look at the long-run effects of an increase in the money supply. The output level at time B is not a sustainable amount of output because $500 billion exceeds full-employment output, which is only $450 billion. An output level above the full-employment output necessarily means that resources in the economy are being over-utilized. Inflation expectations increase in the long run as a consequence of over-utilization, which causes the inflation rate to gradually increase from SRAS1 to SRAS2.

As the inflation rate increases, the central bank frantically tries to contain inflation by increasing the interest rate which reduces output gradually from $500 billion to $450 billion.

The bad effects come later--in the long run, the monetary expansion leads to soaring inflation without creating any new jobs. Historically, a high inflation rate is associated with lower rates of long-run economic growth. High inflation rates create uncertainty about future production costs and the future purchasing power of the currency. As a result, high inflation tends to discourage saving and investment--both important determinants of long-run economic growth.

The following graphs show the time path for the inflation rate and output between time A and time E. Notice that the good effects occur between time A and B, but the bad effects occur between times B and E.1. Despite the central bank's attempts to reduce inflation between times B and E, the inflation rate inevitably still increases. What can explain this?

2. Suppose the economy is at time E. What must Argentina's central bank do in order to reduce the inflation rate from 12% to 2%? Will this be politically popular?

3. Using the AD-AS model, explain what Friedman means by "When it comes to the cure, it's the other way around, when you stop drinking or when you stop printing money the bad effects come first and the good effects only come later. That's why it's so hard to persist with the cure."

Oil Shock, Part II: The Macroeconomic View

Microeconomists examine how the BP oil field shutdown affects oil prices, the behavior of automobile drivers, and profitability of particular industries. Oil Shock, Part I showed that the oil field shutdown raises the price of oil which reduces the profitability of many firms.

Macroeconomists, on the other hand, examine the economy-wide effects such as how a sharp rise in oil prices affects inflation, output, and unemployment. Suppose that the BP oil field shutdown causes the inflation rate to increase from Inflation Rate 1 to Inflation Rate 2 because firms try to pass on some of the higher input prices to higher output prices. In order to simplify the analysis, assume that full-employment output is constant at FE Output. Full-employment output, or potential output, is the amount of output that the economy produces when all the resources in the economy are efficiently utilized.

If the BP oil field shutdown increases the inflation rate, then the Fed will pursue a tight (anti-inflation) monetary policy which raises interest rates. Higher interest rates would reduce consumption and investment, causing output to fall. An output gap opens up as actual output falls below full-employment output in the short run. In the long run, the output gap will cause the inflation rate to fall back to its initial state. As the inflation rate falls in the long run, the Fed will pursue loose monetary policy and return the economy back to full employment.

A fall in output usually leads to an increase in the unemployment rate as firms cut back on production of goods and services and lay-off workers.

If the BP oil field shutdown leads to an inflation shock, then interest rates will rise, output will fall, and unemployment will increase in the short run.

However, inflation's tyranny does not end there. A higher inflation rate also destroys wealth in terms of stocks and bonds. An increase in the interest rate also reduces the price of stocks and bonds (archived entry: Why Does Bernanke's Small Talk Move Markets?)

1. Financial markets are very sensitive to inflation data. Suppose the Bureau of Labor Statistics reports that the inflation rate increased from 2% to 4%. Why would stock and bond prices fall as soon as the report is released, but before the Fed actually changes any interest rates?

2. The Fed, in its last FOMC meeting on August 8, 2006, kept the federal funds rate unchanged at 5.25%. Could this mean that the Fed does not consider the BP oil field shutdown an inflation shock?

3. Inflation expectations matter. The Fed's inflation-fighting credibility has been strong since Paul Volcker (the Federal Reserve Chairman from 1979 to 1987). Suppose consumers and producers always expect the Fed to return the economy to a target inflation rate--would higher oil prices require the Fed to raise interest rates (or raise them by as much)?

Why Does Bernanke's Small Talk Move Markets?

Consider the Bartiromo Affair: At a media dinner party, Federal Reserve Chairman, Ben Bernanke tells CNBC reporter Maria Bartiromo that Wall Street types underestimate his inflation-fighting credentials and expresses his willingness to continue raising the Fed's interest rate target in order to check inflation. Ms. Bartiromo finds the comments newsworthy, reports the chairman's sentiments on her CNBC program, and sets off a sharp decline in stock prices just before the market closed on Monday, May 1. Keep in mind that stock prices move up and down all of the time for lots of different--often inexplicable--reasons. Ms. Bartiromo's TV show may or may not explain the movements at the end of the day on May 1. Generally, however, changes in interest rates (or expected changes) send stock prices in the opposite direction--that is, interest rates and stock prices are negatively related. Why?

The Fed influences a variety of interest rates in the economy by targeting changes in the federal funds rate. Interest rates have a direct effect on stock values, because investors have required returns they demand for holding financial assets, like stocks. Suppose an investor thinks she can earn a 5% return on her money by purchasing financial assets. Holding risk aside, she will only buy a stock if she expects it to provide a 5% return, but if the Fed raises interest rates, investors will require higher returns for holding stocks.

We can perform a crude stock valuation by assuming a stock will pay a constant dividend forever (a perpetuity) and investors’ returns are derived solely from dividends. Under this assumption, the price, or present value, of a stock simplifies to:

Present Value of Stock = Dividends per Share / Interest Rate

Suppose IBM's stock earns $1 per share. At an interest rate of 5%, the present value of IBM's stock is $1 / 0.05 = $20. If tightened monetary policy raises the interest rate to 6%, our crude valuation model predicts the stock’s value falls to $1 / 0.06 = $16.67. If dividends per share remain constant, an increase in the interest rate reduces stock values.

1. According to this valuation model, what happens to stock prices (present value) when the Fed targets lower interest rates?

2. Peoples' expectations about interest rates or dividends per share change stock values as well. Excessively tight monetary policy (higher interest rates) can lead to an economic recession. What happens to corporate profits during recession? If people expect that tight monetary policy will lead to recession, what will happen to stock values?

3. How did Ms Bartiromo's report about the Fed chair's dinner party comments affect peoples' interest rate expectations? How will a change in interest rate expectations affect required returns and stock valuations?

4. The Federal Reserve is one of the only central banks without an explicit inflation target. As a result, there is still considerable guesswork involved in determining the Fed's tolerance for inflation--that's one reason the Fed chairman's offhand comments receive so much attention. Uncertainty about the inflation target makes it more difficult to anticipate monetary policy. In the absence of clear monetary policy goals, small bits of information that change expectations can disrupt financial markets.

Ben Bernanke is an advocate of explicit inflation targeting--publicly announcing an inflation target and committing the central bank to its achievement. Would an explicit inflation target take some of the mystery out of monetary policy? How would explicit inflation targets change the likelihood of another Bartiromo Affair? How might an explicit inflation target inhibit the Fed's use of monetary policy during an economic crisis?

Nell Henderson offers a more detailed account of the Bartiromo Affair in the Washington Post.

Vikas Bajaj discusses the links between Fed policies and changes in both American and foreign financial markets in a New York Times article.

The idea for the post comes from Paul Romer's Econ 510 community discussion forum. Thanks also to Chris Buzzard for shoring up the finance.