Wages and prices will begin to rise at faster rates if monetary policy stimulates aggregate demand enough to push labor and capital markets beyond their long-run capacities.
In fact, a monetary policy that persistently attempts to keep short-term real rates low will lead eventually to higher inflation and higher nominal interest rates, with no permanent increases in the growth of output or decreases in unemployment. As noted earlier, in the long run, output and employment cannot be set by monetary policy. In other words, while there is a trade-off between higher inflation and lower unemployment in the short run, the trade-off disappears in the long run.
For example, suppose the Fed eases monetary policy. That in itself will raise inflation without big changes in employment and output. In this era of intense global competition, it might seem parochial to focus on U. For example, some argue that even if unemployment in the U. The implication is that inflation is unlikely to rise even if the Fed adopts an easier monetary policy. First, a large proportion of what we consume in the U. More important, perhaps, is the fact that such arguments ignore the role of flexible exchange rates.
If the Fed were to adopt an easier policy, it would tend to increase the supply of U. Ultimately, this would tend to drive down the value of the dollar relative to other countries, as U. Thus, the price of foreign goods in terms of U.
The higher prices of imported goods would, in turn, tend to raise the prices of U. It can take a fairly long time for a monetary policy action to affect the economy and inflation. And the lags can vary a lot, too. Different episodes of monetary policy during this period are indicated in the figure.
Consider Episode 1 in the late s. By , inflation was down to 3. In Episode 2, when economists persuaded the Federal Reserve 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. In , however, it was impossible to stimulate the economy any further by lowering short term rates because they were already as low as they could get.
Read the closing Bring it Home feature for more on this. About the Bank. Monetary Policy. Financial System. Payments and Markets. International Finance. Both fiscal policy and monetary policy can impact aggregate demand because they can influence the factors used to calculate it: consumer spending on goods and services, investment spending on business capital goods, government spending on public goods and services, exports, and imports.
It is often the cause of multiple trilemmas. Fiscal policy affects aggregate demand through changes in government spending and taxation. Those factors influence employment and household income, which then impact consumer spending and investment. Monetary policy impacts the money supply in an economy, which influences interest rates and the inflation rate.
It also impacts business expansion, net exports, employment, the cost of debt, and the relative cost of consumption versus saving—all of which directly or indirectly impact aggregate demand. In order to understand how monetary and policy affect aggregate demand, it's important to know how AD is calculated, which is with the same formula for measuring an economy's gross domestic product GDP :. Fiscal policy determines government spending and tax rates.
Expansionary fiscal policy , usually enacted in response to recessions or employment shocks, increases government spending in areas such as infrastructure, education, and unemployment benefits. According to Keynesian economics , these programs can prevent a negative shift in aggregate demand by stabilizing employment among government employees and people involved with stimulated industries. The theory is that extended unemployment benefits help to stabilize the consumption and investment of individuals who become unemployed during a recession.
Similarly, the theory says that contractionary fiscal policy can be used to reduce government spending and sovereign debt or to correct out-of-control growth fueled by rapid inflation and asset bubbles. In relation to the formula for aggregate demand, the fiscal policy directly influences the government expenditure element and indirectly impacts the consumption and investment elements.
Monetary policy is enacted by central banks by manipulating the money supply in an economy. The money supply influences interest rates and inflation, both of which are major determinants of employment, cost of debt, and consumption levels. Expansionary monetary policy involves a central bank buying Treasury notes, decreasing interest rates on loans to banks, or reducing the reserve requirement.
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