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Late in the Spring of 2003, Fed officials worried that the annual inflation rate might be dropping too low, and they implemented expansionary monetary policy actions.
Actual inflation rose. So did expectations of future inflation. Fed officials concluded society might be better off accepting slightly higher inflation.
How do changes in actual inflation influence the public’s inflation expectations?
– All actions on the part of monetary and fiscal policymakers that are undertaken in response to or in anticipation of some change in the overall economy
1. Government-imposed minimum wage laws, laws restricting entry into occupations, and welfare and unemployment insurance benefits that reduce incentives to work
2. Union activity that sets wages above the equilibrium level and also restricts the mobility of labor
• The Phillips curve: a rationale for active policymaking?
1. The greater the unexpected increase in aggregate demand, the greater the amount of inflation that results in the short run, and the lower the unemployment rate.
2. The greater the unexpected decrease in aggregate demand, the greater the deflation that results in the short run, and the higher the unemployment rate.
Policy Example: When It Comes to Inflation, the fed Keeps Its Eyes Off of the Headlines
• Even though media headlines focus on overall CPI inflation, during the 2000s Federal Reserve Policymakers have paid most attention to core PCE inflation.
• They prefer subtracting out food and energy prices because prices of these items tend to be more volatile than prices of other goods and services.
Policy Example: When It Comes to Inflation, the Fed Keeps Its Eyes Off of the Headlines (cont’d)
• Since the mid-2000s, the forecasting improvements from using current core PCE inflation to forecast future inflation rates have evaporated.
• The differential between overall inflation rates reported in media headlines and the core PCE inflation rate has been widening over time.
• If the public pays more attention to overall inflation rates reported in headlines than to the core PCE inflation rate that is the focus of Fed policy, which actual inflation rate will influence their expectations of future inflation?
Rational Expectations, the Policy Irrelevance Proposition, and Real Business Cycles (cont’d)
• Policy Irrelevance Proposition
– The conclusion that policy actions have no real effects in the short run if the policy actions are anticipated and none in the long run even if the policy actions are unanticipated
Rational Expectations, the Policy Irrelevance Proposition, and Real Business Cycles (cont’d)
• Under the assumption of rational expectations on the part of decision makers in the economy, anticipated monetary policy cannot alter either the rate of unemployment or the level of real GDP.
Rational Expectations, the Policy Irrelevance Proposition, and Real Business Cycles (cont’d)
• Regardless of the nature of the anticipated policy, the unemployment rate will equal the natural rate, and real GDP will be determined solely by the economy’s long-run aggregate supply curve.
Rational Expectations, the Policy Irrelevance Proposition, and Real Business Cycles (cont’d)
• The distinction between real and monetary shocks
– Many economists argue real (as opposed to purely monetary) forces might help explain aggregate economic fluctuations.• Real business cycles and aggregate supply shocks
produced economic stagnation with high inflation “stagflation.”
Modern Approaches to Rationalizing Active Policymaking (cont'd)
• New Keynesian Inflation Dynamics
– In new Keynesian theory, the pattern of inflation exhibited by an economy with growing aggregate demand—initial sluggish adjustment of the price level in response to increased aggregate demand followed by higher inflation later
• New Keynesians say all that matters for is whether such a relationship between inflation and unemployment is exploitablein the near term.
• If so, policymakers can intervene as soon as unemployment and real GDP vary from their long-run levels, thusly dampening cyclical fluctuations and making them short-lived.
• Are New Keynesians correct? – Not all economists agree.– The new classical theory already indicates that
when prices are flexible, higher inflation expectations should reduce short-run aggregate supply and contribute to increased inflation.
– All macroeconomic theories suggest that various factors that push up firms’ production costs should have the same effect on short-run aggregate supply and inflation in a flexible-price economy.
Summing Up: Economic Factors Favoring Active versus Passive Policymaking
• Most economists agree that active policymaking is unlikely to exert sizable long-run effects on any nation’s economy.
• Most agree that aggregate supply shocks contribute to business cycles.
• Some argue that monetary and fiscal policy actions can offset, at least in the short run and possibly in the long-run the effects that aggregate demand shocks would otherwise have on real GDP and unemployment.
Issues and Applications: Are U.S. Inflation Expectations Rising?
• New Keynesian inflation dynamics indicate that the public’s expectations of future inflation are a fundamental determinant of the current inflation rate.
• Thus, expectations of low inflation become self-fulfilling. Economists are concerned that the Fed may be tempted to exploit expectations of low future inflation, engage in inflationary policies, and thereby boost inflation expectations and then be difficult to bring back down.
Issues and Applications: Are U.S. Inflation Expectations Rising? (cont’d)
• Figure 18-11 provides evidence about how the Fed’s policy strategy following the spring of 2003 affected the public’s inflation expectations.
• Why do you suppose that some economists doubt the new Keynesian view that variations in inflation expectations and per-unit real production costs, rather than changes in money supply growth, are the main determinants of inflation?
Summary Discussion of Learning Objectives (cont'd)
• How expectations affect the actual relationship between the inflation rate and the unemployment rate– Theory predicts that there will be a Phillips curve
relationship only when expectations are unchanged.
– Only unanticipated policy actions affect short-run real GDP
– Policy irrelevance theorem
– Technological changes and labor market shocks can induce business fluctuations, called real business cycles, which weaken the case for active policymaking