Chapter 24

Learning Objectives
24.1 Illustrate and Preview

B
explain the policy etween September 2007 and December 2008, the Federal Reserve lowered the
choices that monetary target for its policy interest rate, the federal funds rate, from 514% all the way
policymakers face under down to zero and continued to keep it there for more than seven years afterward.
the conditions of aggre- Why did the Fed lower interest rates so aggressively and continue to keep them so low?
gate demand and aggre- Could this monetary policy easing have sparked undesirable inflation? Many com-
gate supply shocks. mentators in the media thought so. Starting in the early 1960s, when the inflation rate
24.2 Identify the lags in hovered between 1% and 2%, the economy began to suffer from higher and more vari-
the policy process, and able rates of inflation. By the late 1960s, the inflation rate had climbed to beyond 5%,
summarize why they and by 1974, it reached the double-digit level. After moderating somewhat during the
weaken the case for an 1975–1978 period, it shot above 10% in 1979 and 1980, decreased to around 5% from
activist policy approach. 1982 to 1990, declined further to around 2% in the late 1990s, and then climbed
24.3 Explain why mon- above the 5% level in 2008. Subsequently, the inflation rate fell to below the 2% level.
etary policymakers can Inflation has become a major concern of politicians and the public, and how best to
target any inflation rate in control it is an issue that frequently dominates the discussion of economic policy.
the long run but cannot In this chapter, we will use the aggregate demand/aggregate supply (AD/AS) frame-
target a level of aggregate work developed in Chapter 23 to develop a theory of monetary policy. Specifically, we
output in the long run. will examine the role of monetary policy in stabilizing the economy and creating infla-
24.4 Identify the sources tion. We apply the theory to four big questions: Does stabilizing inflation stabilize out-
of inflation and the role put? Should policy be activist, responding aggressively to fluctuations in economic
of monetary policy in activity, or passive and nonactivist? What are the roots of inflation? How can monetary
propagating inflation. policy work when interest rates cannot go much below zero?
24.5 Explain the unique
challenges that monetary
policymakers face at the
24.1 RESPONSE OF MONETARY POLICY
effective lower bound, TO SHOCKS
and illustrate how non-
LO 24.1 Illustrate and explain the policy choices that monetary policymakers face
conventional monetary
under the conditions of aggregate demand and aggregate supply shocks.
policy can be effective
under such conditions. As we saw in Chapter 17, the primary goal of central banks is price stability: That is,
they try to maintain inflation, p, close to a target level 1pT 2, referred to as an inflation
target, that is slightly above zero. Most central banks set pT between 1% and 3%. In
other words, central banks pursue price stability through monetary policy that aims to
minimize the difference between inflation and the inflation target 1p - pT 2, a differ-
ence economists refer to as the inflation gap.
615
616 PART 6 Monetary Theory
In Chapter 17, we learned that central banks also care about stabilizing economic
activity. Because economic activity can be sustained only at potential output, we can
describe this objective of monetary policy by saying that monetary policymakers want
aggregate output to be close to its potential level, YP. Central banks want to minimize
the difference between aggregate output and potential output (Y - YP), i.e., the output
gap. In our analysis of aggregate demand and supply in Chapter 23, we examined two
categories of economic shocks—demand shocks and supply shocks—and the effects
of each on inflation and output. In this section, we describe a central bank’s policy
responses, given its objectives, to each of these types of shocks. In the case of demand
shocks, policymakers can simultaneously pursue price stability and stability of eco-
nomic activity. In the aftermath of a supply shocks, however, policymakers can achieve
either price stability or economic activity stability, but not both. This trade-off poses a
thorny dilemma for central banks with dual mandates.
Response to an Aggregate Demand Shock

Because we are discussing stabilizing economic activity, we need to focus on output
gaps rather than the level of aggregate output. Thus, in this and the next chapter, we will
conduct all AD/AS analysis in terms of the aggregate output index, in which potential
output has a value of 100, rather than in terms of aggregate output. In all the following
AD/AS diagrams, the label on the horizontal axis is now always going to be the aggregate
output index, and Y represents the aggregate output index rather than aggregate output.
We begin by considering the effects of an aggregate demand shock, illustrated in
Figure 1. For example, the coronavirus pandemic began, in March 2020, to cause both
consumer and business spending to fall. In the figure, the economy is initially at point 1,
where output is at its potential level so the aggregate output index is at YP = 100, and
inflation is at pT. The negative demand shock decreases aggregate demand, shifting
AD1 to the left to AD2. Policymakers can respond to this shock in two possible ways.
No Policy Response If the central bank does not respond by changing the auton-
omous component of monetary policy, the aggregate demand curve remains at AD2,
and so the economy moves to the intersection of AS1 and AD2. Here, the aggregate out-
put index falls to Y2, so aggregate output is below potential output, and inflation falls to
p2, below the inflation target of pT. With inflation falling and output below potential,
expected inflation will decline and the short-run aggregate supply curve will shift down
and to the right until it reaches AS3, and the economy will move to point 3. Output will
be back to its potential level at an aggregate output index of YP = 100 and inflation
will fall to a lower level of p3. At first glance, this outcome looks favorable—inflation is
lower and output is back at its potential. But aggregate output will remain below poten-
tial for some time, and if inflation was initially at its target level, the fall in inflation is
undesirable for the reasons outlined in Chapters 12 and 17.
Policy Stabilizes Economic Activity and Inflation in the Short Run Pol-
icymakers can eliminate both the output gap and the inflation gap in the short run by
pursuing policies aimed at increasing aggregate demand to its initial level and return-
ing the economy to its preshock state. The central bank does this by autonomously
easing monetary policy by cutting the real interest rate at any given inflation rate. This
action stimulates investment spending and increases the quantity of aggregate out-
put demanded at any given inflation rate, thereby shifting the AD curve to the right.
As a result, the aggregate demand curve shifts from AD2 back to AD1 in Figure 2,
CHAPTER 24 Monetary Policy Theory 617
Mini-lecture
Inflation LRAS
Rate, p Step 2. decreasing output
and inflation until . . .
AS1
AS3
pT 1
p2 2
Step 1. The aggregate
p3 3 demand curve shifts
leftward . . .
Step 3. the economy AD1

returns to long-run
equilibrium, with inflation
permanently decreased. AD2
Y2 YP = 100
Aggregate Output Index
(potential output = 100), Y
FIGURE 1 Aggregate Demand Shock: No Policy Response

An aggregate demand shock shifts the aggregate demand curve leftward from AD1 to AD2 and moves the
economy from point 1 to point 2, where the aggregate output index falls to Y2 and inflation falls to p2.
With output below potential, the short-run aggregate supply curve shifts down to AS3 and the economy
moves to point 3, where output is back at Y P = 100 but inflation has fallen to p3.
and the economy returns to point 1. (The Federal Reserve took exactly these steps
by lowering the federal funds rate from 5% to 14 % to zero over 15 months starting in
September 2007.)
Our analysis of this monetary policy response shows that in the case of aggre-
gate demand shocks, there is no trade-off between the pursuits of price stability and
economic activity stability. A monetary policy response that focuses on stabilizing
inflation is exactly the monetary policy response that will stabilize economic activity.
No conflict exists between the dual objectives of stabilizing inflation and stabilizing
economic activity, a result that Olivier Blanchard (the chief economist at the Interna-
tional Monetary Fund at the time, formerly a professor at MIT) referred to as the divine
coincidence.
Response to a Supply Shock

When a supply shock occurs—for example, when the price of oil surges because of
political unrest in the Middle East or because of an act of God such as a devastat-
ing hurricane in Florida—the divine coincidence does not hold. Policymakers face a
short-run trade-off between stabilizing inflation and stabilizing economic activity. To
illustrate, we start with the economy at point 1 in Figure 3, where aggregate output is
at the natural rate, so the aggregate output index is at YP = 100 and inflation is at pT.
Mini-lecture
Inflation LRAS
Rate, p
AS1
Step 3. Autonomous easing of monetary

policy shifts the aggregate demand curve
pT 1 back to AD1 and the economy returns to
p2 2 long-run equilibrium, with inflation
stabilized at pT.
AD1
Step 2. decreasing
output and inflation. Step 1. The aggregate
AD2 demand curve shifts
leftward . . .
Y2 YP = 100
FIGURE 2 Aggregate Demand Shock: Policy Stabilizes Output and Inflation in the Short Run
An aggregate demand shock shifts the aggregate demand curve leftward from AD1 to AD2 and moves the econ-
omy from point 1 to point 2, where the aggregate output index falls to Y2 and inflation falls to p2. An autono-
mous easing of monetary policy lowers the real interest rate at any given inflation rate and shifts the AD curve
back to AD1. Aggregate output returns to potential at point 1, and inflation returns to its target level.
The negative supply shock—from, say, a rise in the price of oil—shifts the short-run
aggregate supply curve up and to the left, from AS1 to AS2.The economy moves to point 2,
with inflation rising to p2 and the aggregate output indexing falling to Y2. Policymakers
can respond to the supply shock in three possible ways.
No Policy Response One potential policy choice is to refrain from making an

autonomous change in monetary policy so that the aggregate demand curve does not
shift. Since aggregate output is less than potential output, eventually the short-run
aggregate supply curve will shift back down to the right, returning to AS1. The economy
will return to point 1 in Figure 3, and both the output and inflation gaps will close as
output and inflation return to their initial levels of YP = 100 and pT, respectively. Both
inflation and economic activity will stabilize over time. While we wait for the long run,
however, the economy will undergo a painful period of reduced output and higher
inflation rates. To avoid this period of reduced output and high inflation, monetary pol-
icymakers might decide to try to stabilize economic activity or inflation in the short run.
Policy Stabilizes Inflation in the Short Run A second policy choice for
monetary authorities is to keep inflation at the target level of pT in the short run by
autonomously tightening monetary policy and raising the real interest rate at any given
inflation rate. Doing so will cause investment spending and aggregate demand to fall at
Mini-lecture
Inflation LRAS
Rate, p Step 2. increasing
inflation and decreasing
output. AS2
AS1
2
p2 Step 1. A negative supply
shock shifts the short-run
pT 1 aggregate supply curve
upward . . .
AD1
Step 3. Inflation and economic

activity will stabilize in the long run.
Y2 YP = 100
(potential output = 100) Y
FIGURE 3 Response to a Supply Shock: No Policy Response

A negative supply shock shifts the short-run aggregate supply curve upward from AS1 to AS2, moving the
economy to point 2, with inflation rising to p2 and the aggregate output index falling to Y2. If the autono-
mous monetary policy remains unchanged, the short-run aggregate supply curve will shift back down and
to the right in the long run, eventually returning to AS1, and the economy will move back to point 1.
each inflation rate, shifting the aggregate demand curve to the left to AD3 in Figure 4.
The economy now will move to point 3, where the aggregate demand curve AD3 inter-
sects the short-run aggregate supply curve AS2 at an inflation rate of pT. Because output
is below potential at point 3, the short-run aggregate supply curve will shift back down
to AS1. To keep the inflation rate at pT, the monetary authorities will need to move the
short-run aggregate demand curve back to AD1 by reversing the autonomous tighten-
ing, and eventually the economy will return to point 1.
As Figure 4 illustrates, stabilizing inflation reduces the aggregate output index to Y3
in the short run, and only over time will output return to potential output at an aggre-
gate output index of YP = 100. Stabilizing inflation in response to a supply shock
leads to a larger deviation of aggregate output from potential, so this action does not
stabilize economic activity.
Policy Stabilizes Economic Activity in the Short Run A third policy choice
is for monetary policymakers to stabilize economic activity rather than inflation in the
short run by increasing aggregate demand. According to Figure 5, this policy decision
will shift the aggregate demand curve to the right to AD3, where it intersects the short-
run aggregate supply curve AS2 and the long-run aggregate supply curve LRAS at point 3.
To achieve this result, policymakers will have to autonomously ease monetary policy
by lowering the real interest rate at any given inflation rate. At point 3, the output gap
Mini-lecture
Step 1. A negative supply

Inflation LRAS1 aggregate supply curve
Rate, p upward.
AS2
AS1
2 Step 3. The short-run

p2 aggregate supply curve
shifts downward . . .
pT 3 1
Step 2. Autonomous
tightening of monetary
AD1 policy shifts the aggregate
demand curve to AD3,
AD3 leading to a decline in
output, but keeping inflation
at pT.
Step 4. leading policymakers to Y3 Y2 Y P = 100

autonomously ease monetary policy Aggregate Output Index
to shift the aggregate demand curve (potential output = 100), Y
back to AD1 stabilizing inflation and
output in the long run.
FIGURE 4 Response to a Supply Shock: Short-Run Inflation Stabilization

A negative supply shock shifts the short-run aggregate supply curve from AS1 to AS2, moving the economy
to point 2, with inflation rising to p2 and the aggregate output index falling to Y2. Autonomous tighten-
ing of monetary policy shifts the aggregate demand curve to the left to AD3, and the economy moves to
point 3, where inflation is at pT. With output below potential at point 3, the short-run aggregate supply
curve shifts back to AS1. To keep the inflation rate at pT, the autonomous tightening of monetary policy is
reversed, shifting the aggregate demand curve back to AD1 and the economy back to point 1.
returns to zero, so monetary policy has stabilized economic activity. However, inflation
has risen to p3, which is greater than pT, and so inflation has not been stabilized. Stabi-
lizing economic activity in response to a supply shock results in a larger deviation of
inflation from the inflation target rather than a stabilization of inflation.
The Bottom Line: The Relationship Between Stabilizing

Inflation and Stabilizing Economic Activity
We can draw the following conclusions from our analysis:
1. If most shocks to the economy are aggregate demand shocks, then policy that
stabilizes inflation will also stabilize economic activity, even in the short run.
2. If supply shocks are the most common type of shock, then a central bank must
choose between the two stabilization objectives in the short run.
Mini-lecture
Inflation Step 4. Output has stabilized LRAS

Rate, p at potential, but inflation is
higher than the target level.
AS2
AS1
p3 3 Step 1. A negative supply

p2 aggregate supply curve
pT 2 1 upward . . .
AD3
Step 2. leading to a Step 3. Autonomous easing
rise in inflation and AD1 of monetary policy shifts
a fall in output. the AD curve rightward.
Y2 YP = 100
FIGURE 5 Response to a Supply Shock: Short-Run Output Stabilization

A negative supply shock shifts the short-run aggregate supply curve from AS1 to AS2, moving the economy
to point 2, with inflation rising to p2 and the aggregate output index falling to Y2. To stabilize output,
autonomous monetary policy easing shifts the aggregate demand curve rightward to AD3. At point 3, the
monetary policy action has stabilized economic activity, but inflation at p3 is greater than the target level pT.
24.2 HOW ACTIVELY SHOULD POLICYMAKERS TRY

TO STABILIZE ECONOMIC ACTIVITY?
LO 24.2 Identify the lags in the policy process, and summarize why they weaken the
case for an activist policy approach.
All economists have similar policy goals (to promote high employment and price sta-
bility), yet they often disagree on the best approach for achieving these goals. Suppose
policymakers confront an economy that has high unemployment resulting from a nega-
tive demand or supply shock that has reduced aggregate output. Nonactivists believe
that wages and prices are very flexible and that the self-correcting mechanism works
very rapidly. They argue that the short-run aggregate supply curve will shift downward
quickly, returning the economy to full employment rapidly. They thus believe that gov-
ernment action to eliminate unemployment is unnecessary. Activists, many of whom
are followers of Keynes and are thus referred to as Keynesians, regard the self-
correcting mechanism, which works through wage and price adjustment, as a very slow-
working mechanism because of the stickiness of wages and prices. Thus they believe it
will take the economy a very long time to reach the long run, agreeing with Keynes’s
famous adage that “In the long-run, we are all dead.” Activists therefore believe that the
government should pursue active policies to increase aggregate demand and eliminate
high unemployment when it develops.
Lags and Policy Implementation

If policymakers could shift the aggregate demand curve instantaneously, activist poli-
cies could be used to move the economy immediately to the full-employment level, as
we saw in the previous section. However, several types of lags prevent this immediate
shift from occurring, and there are differences in the lengths of these lags for monetary
versus fiscal policy.
1. The data lag is the time it takes for policymakers to obtain the data that describe
what is happening in the economy. Accurate data on GDP, for example, are not
available until several months after a given quarter is over.
2. The recognition lag is the time it takes for policymakers to feel confident about
the signals the data are sending about the future course of the economy. For exam-
ple, to minimize errors, the National Bureau of Economic Research (the private
organization that officially dates business cycles) will not declare the economy to
be in recession until at least six months after it has determined that a recession has
begun.
3. The legislative lag represents the time it takes to get legislation passed to imple-
ment a particular policy. The legislative lag does not apply to most monetary pol-
icy actions, such as the lowering of interest rates. It is, however, important in the
implementation of fiscal policy, because it can sometimes take six months to a year
to get legislation passed to change taxes or government purchases.
4. The implementation lag is the time it takes for policymakers to change policy
instruments once they have decided on a new policy. Again, this lag is less important
for the conduct of monetary policy, because the Federal Reserve can immediately
change its policy interest rate, whereas it is more important for the implementation
of fiscal policy. The implementation of new fiscal policy can take substantial time;
for example, getting government agencies to change their spending habits takes
time, as does changing tax tables.
5. The effectiveness lag is the time it takes for the policy to have a real impact on the
economy. The effectiveness lag is both long (often a year long or longer) and vari-
able (that is, substantial uncertainty exists about the length of this lag).
The existence of these lags makes the policymakers’ job far more difficult and
therefore weakens the case for activism. When unemployment is high, activist policy
aimed at shifting the aggregate demand curve rightward to restore the economy to full
employment may not produce desirable outcomes. Indeed, if the policy lags described
above are very long, then by the time the aggregate demand curve shifts to the right, the
self-correcting mechanism may have already returned the economy to full employment.
Then, when the activist policy kicks in, it may cause output to rise above potential,
leading to a rise in inflation. In situations in which policy lags are longer than the time
it takes the self-correcting mechanism to work, a policy of nonactivism may produce
better outcomes.
The activist/nonactivist debate came to the fore when the Obama administration advo-
cated a fiscal stimulus package early in its administration in 2009 (see the FYI box “The
Activist/Nonactivist Debate over the Obama Fiscal Stimulus Package”). In Chapter 25,
we will return to the issue of just how active policy should be when we look at the role
that expectations play in monetary policy.
FYI The Activist/Nonactivist Debate Over the Obama Fiscal Stimulus Package
When President Obama took office in January 2009, The economics profession was split over the desir-
he faced a very serious recession, with unemploy- ability of fiscal stimulus. Approximately 200 econo-
ment at over 7% and rising rapidly. Although policy- mists who opposed fiscal stimulus signed a petition
makers had been using monetary policy aggressively published in the Wall Street Journal and the New York
to stabilize the economy (see Chapters 12 and 16), Times on January 28, 2009. An opposing petition,
many activists argued that the government needed also signed by about 200 economists, was sent to the
to do more by implementing a massive fiscal stimu- U.S. Congress on February 8. The Obama admin-
lus package. They argued that without the stimulus istration came down squarely on the side of the
package, monetary policy, which had already low- activists and proposed the American Recovery and
ered the federal funds rate to close to zero and so Reinvestment Act of 2009, a $787 billion fiscal stim-
could not lower nominal interest rates further, would ulus package that was passed by Congress on Febru-
be unable to increase aggregate demand to the full- ary 13, 2009. In the House, the vote in favor of the
employment level. In contrast, nonactivists opposed stimulus package was 244 to 188, with 177 Republi-
the fiscal stimulus package, arguing that fiscal stim- cans and 11 Democrats opposing the bill. In the Sen-
ulus would take too long to work because of long ate, the vote was 61 to 37, with all 58 Democrats and
implementation lags. They cautioned that if the fis- 3 Republicans supporting the bill. Even after the fact,
cal stimulus kicked in after the economy had already the value of the 2009 stimulus package is still hotly
recovered, the result would be increased volatility in debated, with some believing it helped stabilize the
inflation and economic activity. economy and others believing it was not effective.
24.3 INFLATION: ALWAYS AND EVERYWHERE A MONETARY

PHENOMENON
LO 24.3 Explain why monetary policymakers can target any inflation rate in the long
run but cannot target a level of aggregate output in the long run.
Milton Friedman is famous for his adage that in the long run, “Inflation is always
and everywhere a monetary phenomenon.” This adage is supported by our aggregate
demand and supply analysis, which asserts that monetary policymakers can target any
inflation rate in the long run by shifting the aggregate demand curve through autono-
mous monetary policy. As an illustration, look at Figure 6, where the economy is at
point 1, with aggregate output at potential output, so the aggregate output index is at
YP = 100, and inflation is at an initial inflation target of pT1.
Suppose the central bank believes that this inflation target is too low and chooses to
raise it to pT3. The central bank eases monetary policy autonomously by lowering the real
interest rate at any given inflation rate, thereby increasing investment spending and aggre-
gate demand. In Figure 6, the aggregate demand curve shifts to AD3. The economy then
moves to point 2, at the intersection of AD3 and AS1, with inflation rising to p2. Because
aggregate output is above potential output, Y2 7 YP, the short-run aggregate supply curve
shifts up and to the left, eventually stopping at AS3. The economy moves to point 3,
where inflation is at the higher target level of pT3 and the output gap is back at zero.
Mini-lecture
Inflation LRAS
Rate, p Step 2. and inflation rises
to the new, higher target.
AS3
AS1
Step 1. Autonomous
3 monetary policy easing
p T3 shifts the AD curve to
p2 2 the right, and over time,
p T1 the short-run aggregate
supply curve shifts
1
upward . . .
AD3
AD1
YP = 100 Y2
FIGURE 6 A Rise in the Inflation Target

To raise the inflation target to pT3, the central bank undertakes an autonomous monetary policy easing by low-
ering the real interest rate at any given inflation rate, thereby shifting the aggregate demand curve rightward to
AD3. The economy then moves to point 2, and the short-run aggregate supply curve shifts up and to the left,
eventually stopping at AS3. The economy then moves to point 3, with the output gap at zero and inflation at pT3.
The analysis in Figure 6 demonstrates the following key points:

1. The monetary authorities can target any inflation rate in the long run with
autonomous monetary policy adjustments.
2. Potential output—and therefore the quantity of aggregate output produced in the
long run—is independent of monetary policy.
24.4 CAUSES OF INFLATIONARY MONETARY POLICY

LO 24.4 Identify the sources of inflation and the role of monetary policy in propagating
inflation.
If everyone agrees that high inflation is bad for an economy, why do we see so much
of it? Do governments pursue inflationary monetary policies intentionally? We know
that monetary authorities can set the inflation rate in the long run, so it must be that in
trying to achieve other goals, governments end up with overly expansionary monetary
policies and high inflation. In this section, we will examine the government policies
that are the most common sources of inflation.
High Employment Targets and Inflation

One important goal of most governments is high employment, and the pursuit of
this goal can bring on high inflation. The U.S. government is committed by law (the
Employment Act of 1946 and the Humphrey-Hawkins Act of 1978) to engage in activ-
ist policy to promote high employment. Both laws require a commitment to a high level
of employment consistent with stable inflation—yet in practice, the U.S. government
and the Federal Reserve have often pursued a high employment target with little con-
cern for the inflationary consequences of such a policy. This tendency was especially
apparent in the mid-1960s and 1970s, when the government and the Fed began taking
an active role in attempting to stabilize unemployment.
Two types of inflation can result from an activist stabilization policy aimed at pro-
moting high employment:
1. Cost-push inflation results from either a negative supply shock or a push by
workers for wage hikes that are beyond those justified by productivity gains.
2. Demand-pull inflation results when policymakers pursue policies that increase
aggregate demand.
We will now use aggregate demand and supply analysis to examine the effects of a
high employment target on both types of inflation.
Cost-Push Inflation Consider the economy shown in Figure 7, which is initially

at point 1, the intersection of the aggregate demand curve AD1 and the short-run aggre-
gate supply curve AS1. Suppose workers succeed in pushing for higher wages, either
because they want to increase their real wages (their wages in terms of the goods and
services they can buy) above the level justified by productivity gains or because they
expect inflation to increase and therefore want their wages to increase accordingly. This
cost-push shock, which acts like a negative supply shock, raises the inflation rate and
shifts the short-run aggregate supply curve up and to the left, to AS2. If the central bank
takes no action to change the equilibrium interest rate and the monetary policy curve
remains unchanged, the economy will move to point 2′, at the intersection of the new
short-run aggregate supply curve AS2 and the aggregate demand curve AD1. The aggre-
gate output index will decline to Y′, where output is below potential output, and the
inflation rate will rise to p2′, leading to an increase in unemployment.
In contrast, activist policymakers with a high employment target would imple-
ment policies to increase aggregate demand, such as tax cuts, increases in government
purchases, or an autonomous easing of monetary policy. These policies would shift
the aggregate demand curve in Figure 7 to AD2, quickly returning the economy to
potential output at point 2 and increasing the inflation rate to p2. The workers would
fare quite well, earning both higher wages and government protection against excessive
unemployment.
The workers’ success might encourage them to seek even higher wages. In addi-
tion, other workers might now realize that their wages have fallen relative to their fel-
low workers’ wages, leading them to seek wage increases. These actions will lead to
another negative supply shock, which will cause the short-run aggregate supply curve
in Figure 7 to shift up and to the left again, to AS3. Unemployment will develop again
when we move to point 3′, prompting additional activist policies that will shift the
aggregate demand curve rightward to AD3 and return the economy to full employment
at a higher inflation rate of p3. If this process continues, the result will be a continuing
increase in inflation—a cost-push inflation.
Mini-lecture
Step 4. leading to a Step 1. A negative supply shock

spiraling rise in inflation. shifts the short-run aggregate
Inflation LRAS supply curve upward . . .
Rate, p AS4
AS3
AS2
AS1
p4 4
4'
p3 3 Step 3. Policymakers
3' increase aggregate
p2 2 demand in response . . .
p 2' 2'
p1 1 AD4
AD3
AD2
AD1
Step 2. causing output to fall Y' Y P = 100

and unemployment to increase. Aggregate Output Index
FIGURE 7 Cost-Push Inflation

A cost-push shock (which acts like a negative supply shock) shifts the short-run aggregate supply curve
up and to the left to AS2, and the economy moves to point 2′. To keep aggregate output at potential output
and to lower the unemployment rate, policymakers shift the aggregate demand curve to AD2 so that the
economy will return quickly to potential output at point 2 and an inflation rate of p2. Further upward and
leftward shifts of the short-run aggregate supply curve, to AS3 and beyond, lead the policymakers to con-
tinue increasing aggregate demand, leading to a continuing increase in inflation—a cost-push inflation.
Demand-Pull Inflation A goal of high employment can lead to inflationary fis-

cal and monetary policy in another way. Even at full employment (the natural rate of
unemployment), some unemployment is always present because of frictions in the labor
market that complicate the matching of unemployed workers with employers. Con-
sequently, the unemployment rate when employment is full is still greater than zero.
When policymakers mistakenly underestimate the natural rate of unemployment and
so set a target for unemployment that is too low (i.e., less than the natural rate of unem-
ployment), they set the stage for expansionary monetary policy that produces inflation.
Figure 8 uses aggregate supply and demand analysis to show how this scenario can
unfold. If policymakers set a 4% unemployment target when the natural rate of unem-
ployment is 5%, they are trying to achieve an output target greater than potential out-
put. We mark this target level of the aggregate output index in Figure 8 as YT. Suppose
the economy is initially at point 1: At this point, the economy is at potential output
but below the target level of the aggregate output index YT. To hit the unemployment
target of 4%, policymakers must enact policies, such as expansionary fiscal policy or an
autonomous easing of monetary policy, to increase aggregate demand. The aggregate
Mini-lecture
Step 3. leading to a Step 2. causing the short-run aggregate

spiraling rise in inflation. supply curve to shift upward in response
Inflation LRAS to rising wages . . .
Rate, p AS4
AS3
AS2
AS1
p4 4
4'
p3 3
3'
p2 2
2'
p1 1 AD4
AD3
Step 1. Policymakers
AD2 increase aggregate
AD1 demand to reach
a higher output target . . .
YP = 100 YT
FIGURE 8 Demand-Pull Inflation

Too low an unemployment target (too high a target for the aggregate output index of Y T) causes the gov-
ernment to increase aggregate demand, shifting the AD curve rightward from AD1 to AD2 to AD3 and so
on. Because at YT the unemployment rate is below the natural rate level, wages will rise and the short-run
aggregate supply curve will shift up and leftward, from AS1 to AS2 to AS3 and so on. The result is a con-
tinuing rise in inflation known as a demand-pull inflation.
demand curve in Figure 8 shifts to the right until it reaches AD2 and the economy
moves to point 2′, where the aggregate output index is at YT and policymakers have
achieved the 4% unemployment rate goal. But there is more to the story. At YT, the 4%
unemployment rate is below the natural rate level and output is above potential, caus-
ing wages to rise. The short-run aggregate supply curve will now shift up and to the
left, eventually reaching AS2 and moving the economy from point 2′ to point 2, where
it is back at potential output but at a higher inflation rate of p2. Because unemployment
is again higher than the target level, policymakers will once more shift the aggregate
demand curve rightward to AD3 in order to hit the output target at point 3′—and the
whole process will continue to drive the economy to point 3 and beyond. The overall
result is a steadily rising inflation rate.
Pursuing too low an unemployment rate target or, equivalently, too high an out-
put target thus leads to inflationary monetary or fiscal policy. Policymakers fail on
two counts: They have not achieved their unemployment target, and they have caused
higher inflation. If the target rate of unemployment is below the natural rate, the process
we see in Figure 8 will be well under way before the policymakers realize their mistake.
Cost-Push Versus Demand-Pull Inflation When inflation occurs, how do

we know whether it is demand-pull inflation or cost-push inflation? We would nor-
mally expect to see demand-pull inflation when unemployment is below the natural
rate level, and to see cost-push inflation when unemployment is above the natural rate
level. Unfortunately, economists and policymakers still struggle with accurately mea-
suring the natural rate of unemployment. Complicating matters further, a cost-push
inflation can be initiated by a demand-pull inflation, blurring the distinction. When
a demand-pull inflation produces higher inflation rates, expected inflation will even-
tually rise and workers will demand higher wages (cost-push inflation) so that their
real wages do not fall. Finally, expansionary monetary and fiscal policies produce both
kinds of inflation, so we cannot distinguish between the two types of inflation on the
basis of their source.
In the United States, as we will see in the following application, the primary reason
for inflationary policy has been policymakers’ adherence to a high employment target.
As we saw in Chapter 20, high inflation can also be caused by persistent government
budget deficits that are financed by increases in the monetary base.
A P P L I C AT I O N The Great Inflation

Now that we have examined the roots of inflationary monetary policy, we can investi-
gate the causes of the rise in U.S. inflation that occurred from 1965 to 1982, a period
dubbed the “Great Inflation.”
Panel (a) of Figure 9 documents the rise in inflation during these years. Just before
the Great Inflation started, the inflation rate was below 2% at an annual rate; by the late
1970s, it averaged around 8%. It peaked at over 14% in 1980 after an oil price shock in
1979. Panel (b) of Figure 9 compares the actual unemployment rate to estimates of the
natural rate of unemployment. Notice that the economy experienced unemployment
below the natural rate in every year but one between 1960 and 1973, as represented by
the shaded areas. This insight suggests that from 1960–1973, the U.S. economy experi-
enced the demand-pull inflation we described in Figure 9. That is, in trying to achieve
an output target that was too high, policymakers pursued a policy of autonomous mon-
etary policy easing that shifted the aggregate demand curve to the right and created a
positive output gap, thereby increasing inflation. Policymakers, economists, and politi-
cians were committed in the mid-1960s to a target unemployment rate of 4%, a level
of unemployment they believed to be consistent with price stability. In hindsight, most
economists today agree that the natural rate of unemployment was substantially higher
in the 1960s and 1970s, between 5% and 6%, as shown in panel (b) of Figure 9. The
inappropriate 4% unemployment target initiated the most sustained inflationary epi-
sode in U.S. history.
Panel (b) of Figure 9 shows that after 1974, the unemployment rate remained
above the natural rate of unemployment (see shaded area), with the exception of a
brief period in 1978 and 1979, and yet inflation continued, per panel (a), indicating
a cost-push inflation such as we described in Figure 7 (the impetus for which was
the earlier demand-pull inflation). The public’s knowledge that government policy
was aimed squarely at high employment explains the persistence of inflation. The
higher rate of expected inflation from the demand-pull inflation shifted the short-run
aggregate supply curve in Figure 7 upward and to the left, causing a rise in unem-
ployment that policymakers tried to eliminate by autonomously easing monetary
Panel (a) Inflation, 1965–1982

16% Step 4. suggesting a
cost-push inflation.
14%
12%
Inflation (percent)
10%
Step 2. leading to
8%
demand-pull inflation.
6%
4%
2%
0%
1960 1965 1970 1975 1980
Year
Panel (b) Unemployment and the Natural Rate of Unemployment, 1965–1982

12%
Unemployment Rate (percent)
Step 3. Unemployment was

10% above the natural rate . . .
8%
6%
4%
2% Step 1. Unemployment was

below the natural rate . . .
0%
1960 1965 1970 1975 1980
Year
Natural Rate of Unemployment Unemployment Rate
FIGURE 9 Inflation and Unemployment, 1965–1982

As shown in panel (a), the CPI inflation rate was below 2% at an annual rate in the early 1960s, but by
the late 1970s, it was averaging around 8%. It peaked at over 14% in 1980 following an oil price shock in
1979. As shown in panel (b), the economy experienced unemployment below the natural rate in every
year but one between 1960 and 1973, suggesting a demand-pull inflation as described in Figure 8. After
1975, the unemployment rate was regularly above the natural rate of unemployment, suggesting a cost-
push inflation as delineated in Figure 7.
Source: Economic Report of the President.
policy, shifting the aggregate demand curve to the right. The result was a continuing
rise in inflation.
Only when the Federal Reserve, under Fed chair Paul Volcker, committed to an
anti-inflationary monetary policy, which involved hiking the federal funds rate to the
20% level, did inflation come down, ending the Great Inflation. ◆
24.5 MONETARY POLICY AT THE EFFECTIVE LOWER BOUND

LO 24.5 Explain the unique challenges that monetary policymakers face at the effective
lower bound, and illustrate how nonconventional monetary policy can be effective
under such conditions.
So far we have assumed that a central bank can continue to lower the real interest rate
as inflation falls by lowering its policy rate—say, the federal funds rate—so that the MP
curve is always upward-sloping. However, because the federal funds rate is a nominal
interest rate, it can never fall much below a value of zero. A negative federal funds
rate well below zero would imply that banks are willing to earn a much lower return
by lending in the federal funds market than they could earn by holding cash in their
vaults, with its zero rate of return. As discussed in Chapter 16, the floor on the policy
rate is referred to as the effective lower bound, and it creates a particular problem for the
conduct of monetary policy.
Deriving the Aggregate Demand Curve with the

Effective Lower Bound
To understand more deeply the problems created by the effective lower bound with
regard to the conduct of monetary policy, let’s look at what happens to the aggregate
demand curve when a central bank cannot lower its policy rate much below zero. A
key fact in this analysis is that the real interest rate is the interest rate that is adjusted
for expected inflation, i.e., the real rate equals the nominal rate minus expected infla-
tion, r = i - pe. Panel (a) of Figure 10 shows an MP curve that hits the effective lower
bound, which, for simplicity, we will assume is zero, although it could be slightly less
than zero. For our purposes, let’s assume that expected inflation moves closely with
the actual inflation rate (as it usually does), as indicated on the horizontal axis in panel
(a). Let’s start at point 3 on the MP curve, where inflation is at 3% and the real inter-
est rate is at 2%. Now let’s see what happens as inflation falls from 3% to 2%. At this
inflation level, the monetary authorities will want to lower the real interest rate to,
say, - 2% (point 2 in panel (a)), which will require them to lower the policy rate to
zero 1r = 0 - 2% = - 2%2. At point 2 in panel (a), the effective lower bound has
been reached on the MP curve. So far, our analysis is identical to the analysis given in
Chapter 22, with the MP curve having the usual upward slope.
Now, what happens if the inflation rate falls even further—say, to 1%? The mon-
etary authorities would like to lower the real interest rate by lowering the policy rate
again, but they can’t because the policy rate has already hit the floor of the effective lower
bound (which we are assuming is equal to zero). Indeed, as indicated by point 1 on the
MP curve, with the nominal policy rate at the effective lower bound at zero, the real
interest rate at an inflation rate of 1% has now risen to - 1% 1r = 0 - 1% = - 1%2.
Hence, we see that the segment of the MP curve that connects point 2 to point 1 is
downward-sloping, the opposite of what we found in Chapter 22.
Now let’s see what happens to the aggregate demand curve, shown in panel (b) of
Figure 10. At a 3% inflation rate and a real interest rate of 2% (point 3 on the MP curve
in panel (a)), the equilibrium level of the aggregate output index is, say, 90, marked as
point 3 on the aggregate demand curve in panel (b). Now, when inflation falls to 2%
and the real interest rate is at - 2%, as indicated by point 2 on the MP curve in panel (a),
the aggregate output index rises to 100 because planned investment spending rises with
the lower real interest rate. The inflation rate of 2% and level of the aggregate output
Mini-lecture
Panel (a): MP Curve

Real MP
Interest
Rate,
r (percent)
2 3
Step 2. but has a downward slope
1 from point 1 to point 2 because at the Step 1. The MP curve
zero lower bound, as inflation rises has the usual upward
the real rate falls. slope from point 2 to
0 point 3. . .
1
–1
Effective lower
2 bound
–2
1 2 3
Inflation Rate, p (percent)
Panel (b): Aggregate Demand Curve

Inflation
Rate,
p (percent) Step 3. The AD curve
AD has the usual downward
3 slope from point 3 to
3 point 2. . .
Effective lower
2 bound
2
Step 4. but has an upward

1 slope from point 1 to point 2
1 because at the zero lower
bound, as inflation rises, the
real interest rate falls and
output increases.
90 95 100
FIGURE 10 Derivation of the Aggregate Demand Curve with an Effective Lower Bound
In panel (a), the MP curve has the usual upward slope in going from point 2 to point 3, but it slopes
downward in the segment from point 1 to point 2 because, with the policy rate at the floor of the effective
lower bound, as inflation and expected inflation fall, the real interest rate rises. This produces a kink in
the aggregate demand curve, as shown in panel (b).
index is marked as point 2 on the AD curve in panel (b). This point is also at the effec-
tive lower bound. The AD curve has the usual downward slope from point 3 to point 2.
However, if inflation falls to 1%, point 1 on the MP curve indicates that the real
interest rate will rise to - 1% because, at the effective lower bound, where the nomi-
nal policy rate is stuck near zero the decrease in both inflation and expected inflation
will raise the real interest rate. The rise in the real interest rate will cause the aggregate
output index to fall, to 95 at point 1 on the AD curve in panel (b). Therefore, in going
from point 1 to point 2, the aggregate demand curve slopes upward rather than down-
ward. The presence of the effective lower bound thus can produce a kinked aggregate
demand curve of the type seen in panel (b).
The Disappearance of the Self-Correcting Mechanism

at the Effective Lower Bound
Now let’s analyze what happens in our aggregate demand and supply diagram when
the economy is hit by a large negative shock, such as the shock that occurred during
the global financial crisis from 2007 to 2009 (see Chapter 12), so that the effective
lower bound becomes binding. In this situation, the initial short-run aggregate sup-
ply curve intersects the upward-sloping part of the aggregate demand curve at point 1
in Figure 11, where the aggregate output index is at Y1, which is less than YP = 100.
Mini-lecture
AD LRAS
Inflation
Rate, Step 3. With more
p (percent) slack in the economy,
AS shifts down further . . .
Step 1. With slack in
the economy, AS AS1
shifts down . . .
1 AS2
p1
AS3
2
p2
3 Step 2. leading to a
p3 decrease in output
and inflation.
Step 4. leading
to a downward
spiral in output
and inflation. Y3 Y2 Y1 YP = 100
FIGURE 11 The Absence of the Self-Correcting Mechanism at the Effective Lower Bound
At the initial equilibrium at point 1, Y1 6 Y P, so the short-run aggregate supply curve shifts down to AS2
and the economy moves to point 2, where the aggregate output index and inflation have fallen to Y2 and p2,
respectively. Because Y2 is even lower relative to Y P, the short-run aggregate supply curve shifts down even
further to AS2, and the economy moves to point 3, where the aggregate output index and inflation have fallen
even further, to Y3 and p3, respectively. Both output and inflation therefore experience downward spirals.
Because Y1 6 YP, there is slack in the economy, and so the short-run aggregate supply
curve will fall to AS2 and the economy will move to point 2, at the intersection of the
AS2 and AD curves, where inflation and the aggregate output index will have declined
to p2 and Y2, respectively. Now, Y2 is even lower relative to YP, so the short-run aggre-
gate supply curve will shift down even further, to AS3, and the economy will move to
point 3, where inflation and the aggregate output index have fallen even further, to p3
and Y3, respectively.
Our analysis of Figure 11 reveals two key results:
• First, the self-correcting mechanism is no longer operational. When the economy
is in a situation in which equilibrium output is below potential output and the
effective lower bound on the policy rate has been reached, output is not restored
to its potential level if policymakers do nothing. Indeed, the opposite occurs—the
economy goes into a downward spiral.
• Second, in this situation, the economy goes into a deflationary spiral, characterized
by continually falling inflation and output.
The intuition behind these two results is fairly straightforward. When output is below
potential and the policy rate has hit the floor of the effective lower bound, the resulting
fall in inflation leads to higher real interest rates, which depress output further, which
causes inflation to fall further, and so on. Schematically, this chain of events can be
expressed as follows:
Y 6 YP 1 p T 1 r c 1 YT 1 Y V YP 1 p T 1 r c 1 YT
The final outcome is that both output and inflation go into downward spirals.
A P P L I C AT I O N Nonconventional Monetary Policy

and Quantitative Easing
At the effective lower bound, conventional expansionary monetary policy is no lon-
ger an option because the monetary policy authorities are unable to lower the policy
rate. As a result, the central bank has to turn to the nonconventional policies dis-
cussed in Chapter 16 to stimulate the economy. Here we will analyze how these
different nonconventional policies lead to economic expansion while avoiding the
downward spirals in output and inflation that characterized the situation described
in Figure 11.
Recall that nonconventional monetary policy takes three forms: liquidity provision,
asset purchases (quantitative easing), and management of expectations. To see how
each of these forms works, recall from Chapter 21 that the real interest rate for invest-
ments ri reflects not only the short-term real interest rate set by the central bank, r, but
also an additional term f , which we referred to previously as financial frictions. This
relationship can be written mathematically as follows
ri = r + f (1)
Each of these nonconventional monetary policy measures helps raise aggregate output
and inflation by lowering f in the AD/AS model. Let’s look at each of these measures
in turn.
Mini-lecture
Inflation
Step 1. Nonconventional monetary policy
Rate, lowers financial frictions and shifts AD
p (percent) to the right . . .
LRAS
AD1 AD2
AS
p2
2
1 Step 2. increasing
p1
output and inflation.
Y1 Y2=Y P = 100
FIGURE 12 Response to Nonconventional Monetary Policy

Nonconventional monetary policy, whether it involves liquidity provision, asset purchases, or manage-
ment of expectations, lowers f , which in turn lowers the real interest rate for investments at any given
inflation rate and shifts the aggregate demand curve to AD2. The economy moves to point 2, where the
aggregate output index and inflation have risen to Y2 and p2, respectively.
Liquidity Provision
The effective lower bound situation depicted in Figure 12 often arises when credit
markets seize up and there is a sudden shortage of liquidity, as occurred during the
2007-2009, global financial crisis. The shortage of liquidity results in a sharp rise in
financial frictions, which shifts the aggregate demand curve to AD1 in Figure 12 to
point 1, where it intersects the aggregate supply curve and where the policy rate has
hit a floor of the effective lower bound and output is below potential. A central bank
can bring down financial frictions directly by increasing its lending facilities in order
to provide more liquidity to impaired markets so that they can return to their normal
functions, thereby bringing down the f term. As we saw in Chapter 23, this decline
in financial frictions lowers the real interest rate for investments, ri = r + f , and so
increases investment spending and the quantity of aggregate output demanded at any
given inflation rate. The aggregate demand curve then shifts to the right to AD2 and
the economy moves to point 2, where both output and inflation have risen. Indeed, if
liquidity provisions are sufficiently successful, the economy can move back to its full
employment level, where output will return to potential, as indicated by point 2 in
the figure.
Asset Purchases and Quantitative Easing

The monetary authorities can also lower the f term by lowering credit spreads through
the purchase of privately issued securities. When the monetary authorities purchase
a private security, such a purchase raises the security’s price and therefore lowers
its interest rate, thereby lowering the credit spread and hence f and the real interest
rate for investments. The decline in the real interest rate for investments at any given
inflation rate then causes the aggregate demand curve to shift to the right, as shown in
Figure 12, and raises both output and inflation.
Because investments typically are associated with long-term projects, the real inter-
est rate for investments is likely to be a long-term interest rate and therefore differs
from the short-term real interest rate r. Hence the f term in Equation 1 can be viewed
as reflecting not only financial frictions and credit spreads but also the spread between
long-term and short-term rates. This means that asset purchases of long-term govern-
ment securities also can lower the real interest rate for investments. When the Federal
Reserve purchases long-term U.S. Treasury bonds, for example, this action raises their
price and lowers long-term interest rates. The result is a decline in f and the real inter-
est rate for investments at any given inflation rate, and so the aggregate demand curve
will shift to the right, to AD2 in Figure 12, thereby raising output and inflation.
When a central bank engages in liquidity provision or asset purchases, its balance
sheet necessarily expands. Indeed, as we saw in Chapter 16, from before the financial
crisis began in September 2007 through 2014, the value of Federal Reserve assets rose
from about $800 billion to over $4 trillion, and then rose again dramatically starting
in March 2020 in response to the coronavirus pandemic. Such an expansion of the
balance sheet is referred to as quantitative easing because it leads to a huge increase in
liquidity in the economy, which can be a powerful force in stimulating the economy in
the near term and possibly producing inflation down the road.
However, an expansion in the central bank’s balance sheet in and of itself may not
be enough to stimulate the economy. As we saw in our AD/AS analysis of the effective
lower bound, unless quantitative easing is able to lower the real interest rate for invest-
ments, in what former Fed chair Ben Bernanke referred to as a credit easing, there will
be no impact on the aggregate demand curve and hence no impact on output and infla-
tion. If the asset-purchase program involves only the purchase of short-term govern-
ment securities, the program is unlikely to affect credit spreads or the spread between
long- and short-term interest rates, and so f and the real interest rate for investments
will remain unchanged. The result will be a minimal impact on the aggregate economy.1
Indeed, this was the experience in Japan when the Bank of Japan pursued a large-scale
asset-purchase program that primarily involved purchases of short-term government
bonds. Not only did the economy fail to recover but inflation even turned negative.
1
There are two other reasons that quantitative easing in and of itself will not necessarily be stimulative. First, large
expansions in a central bank’s balance sheet do not necessarily result in large increases in the money supply. As
indicated in the application in Chapter 15, “Quantitative Easing and the Money Supply, 2007-2020,” this was
exactly the case in the United States from 2007 to 2014 and again in 2020, when huge expansions in the Fed’s
balance sheet and the monetary base did not result in a large increase in the money supply because most of the
increase in the monetary base just flowed into holdings of excess reserves. Second, an increase in the monetary
base does not mean that banks will increase lending, because they have the option of just adding to their holdings
of excess reserves instead of making loans. This is exactly what happened during the global financial crisis and
the coronavirus pandemic, when a huge increase in the monetary base led primarily to a massive rise in excess
reserves, and bank lending did not increase.
Management of Expectations
One form of management of expectations is forward guidance in which the central
bank commits to keeping the policy rate low for a long period of time, another way of
lowering long-term interest rates relative to short-term rates and thereby lowering f
and the real interest rate for investments. Because investors can choose to invest in a
long-term bond rather than investing in a sequence of short-term bonds, as we saw in
Chapter 6, the interest rate on long-term bonds will be closely related to an average
of the short-term interest rates that markets expect to occur over the life of the long-
term bond. By committing to the future policy action of keeping the federal funds
rate at zero for an extended period, a central bank can lower the market’s expecta-
tions of future short-term interest rates, thereby causing the long-term interest rate to
fall. The result will be a decline in f and the real interest rate for investments, which
will shift the aggregate demand curve to the right as in Figure 12, raising both output
and inflation.
So far, the mechanisms for the efficacy of nonconventional monetary policies have
operated through the f term and rightward shifts in the aggregate demand curve as
in Figure 12. However, management of expectations can also operate through shifts
in the short-run aggregate supply curve that can be achieved by raising expectations
of inflation, as shown in Figure 13. Recall from Chapter 23 that a rise in inflation
expectations—say, because the central bank commits to doing whatever it takes to
raise inflation in the future—will shift the short-run aggregate supply curve up, to AS2
in Figure 13, moving the economy to point 2, where the aggregate output index and
inflation rise to Y2 and p2, respectively. The intuition behind this result is straight-
forward: With the policy rate fixed at the effective lower bound, the rise in expected
inflation will lead to a decline in the real interest rate, which will cause investment
spending and aggregate output to rise as the economy slides up the aggregate demand
curve from point 1 to point 2, as shown in the figure. One problem with this strategy,
however, is that the public must believe that inflation will actually rise in the future.
If the central bank’s commitment to raising inflation is not credible, then inflation
expectations may not rise and this particular type of management of expectations will
not work.
A P P L I C AT I O N Abenomics and the Shift in Japanese

Monetary Policy in 2013
By 2012, the Japanese economy had been in a funk for well over ten years, with very low
growth, the policy rate stuck at the effective lower bound near zero, and the economy
experiencing deflation. With this scenario as his backdrop, Shinzo Abe won the general
election for prime minister of Japan in December 2012, and after taking office he pro-
moted a major shift in economic policy aimed at stimulating economic growth, a policy
that the media has since dubbed “Abenomics.” A key element of Abenomics was a sea
change in monetary policy. First, Abe pressured the Bank of Japan to double its infla-
tion target from 1% to 2% in January 2013, over the objections of the former governor
of the Bank of Japan, Masaaki Shirakawa, who then resigned in March. After taking over
the former governor’s position in March 2013, the new Bank of Japan Governor, Har-
uhiko Kuroda, announced a major change in the way the Bank of Japan would conduct
Mini-lecture
Inflation
Rate,
p (percent) LRAS
AD
Step 1. Expected
inflation rises,
shifting AS upward . . .
AS2
AS1
p2
2
1
p1 Step 2. increasing
output and inflation.
Y1 Y2=Y P = 100
FIGURE 13 Response to a Rise in Inflation Expectations

A rise in inflation expectations causes the short-run aggregate supply curve to shift up to AS2 and the
economy to move to point 2, where the aggregate output index and inflation rise to Y2 and p2, respectively.
monetary policy in the future. First, in contrast to the previous governor, who never
formally committed to achieving the 1% inflation target, Kuroda committed to achieving
the higher 2% inflation objective within two years. Second, he indicated that the Bank
of Japan would now engage in a massive asset-purchase (quantitative easing) program
that would not only double the size of the Bank of Japan’s balance sheet but would also
involve the purchase of a very different set of assets. Specifically, rather than purchas-
ing short-term government bonds, the Bank of Japan would now purchase long-term
bonds, including private securities such as real estate investment trusts.
We can use our analysis from the previous section to predict why this approach
was taken to fix the Japanese economy. First, in contrast to the previous quantitative
easing, the Abenomics program sought to lower f through the purchase of long-term
assets. Specifically, the program would lower f by lowering credit spreads through the
purchase of private securities and also by lowering long-term interest rates through
the purchase of long-term government bonds. As we have seen, with the policy rate at
the effective lower bound, a lower f would lead to a lower real interest rate for invest-
ments, thereby shifting the aggregate demand curve to the right, to AD2 in Figure 14.
Second, the higher inflation target, and even more importantly the stronger com-
mitment by Kuroda to achieving this higher target, should, according to our analysis,
Mini-lecture
Step 1. Asset purchases lower f

shifting AD to the right . . .
Inflation
Rate,
p (percent) LRAS
AD1 AD2
Step 2. and the rise in expected
inflation shifts AS up, . . .
AS2
p2 AS1 Step 3. increasing

2 output and inflation.
p1
1
Y1 Y2=Y P = 100
FIGURE 14 Response to the Shift in Japanese Monetary Policy in 2013

The Bank of Japan’s revised asset-purchase program lowers f , which lowers the real interest rate on
investments at any given inflation rate and shifts the aggregate demand curve to the right, from AD1 to
AD2. The rise in inflation expectations causes the short-run aggregate supply curve to shift upward from
AS1 to AS2. The economy moves to point 2, where the aggregate output index and inflation rise to Y2 and
p2, respectively.
raise expected inflation and hence shift the short-run aggregate supply curve to AS2. As
we can see in Figure 14, the economy would then move to point 2, where both output
and inflation would rise.
In other words, the new monetary policy’s two-pronged attack would both lower
the real interest rate for investments directly through the asset-purchase program and
also directly raise inflation expectations, providing another factor that would drive
down the real interest rate. Both of these mechanisms would then operate to promote
an economic expansion and an exit from the deflationary environment that the Japa-
nese had been experiencing for the past 15 years. Although this new policy strategy has
helped raise Japanese inflation above zero and has led to lower unemployment, it has
not been successful in raising Japanese inflation to the 2% target. This failure illustrates
how difficult it is to raise inflation expectations once a prolonged period of deflation
has occurred. ◆
SUMMARY
1. For aggregate demand shocks, the price stability and monetary policy, which makes use of the federal funds
economic activity stability objectives are consistent: rate policy tool to change the level of aggregate demand
Stabilizing inflation stabilizes economic activity, even and thereby adjust the equilibrium inflation rate.
in the short run. For supply shocks, however, there is 4. Two types of inflation can result from an activist stabi-
a trade-off between stabilizing inflation and stabiliz- lization policy aimed at promoting high employment:
ing economic activity in the short run. In the long run, cost-push inflation, which is caused by negative sup-
however, there is no conflict between stabilizing infla- ply shocks or a push by workers for wages that are
tion and stabilizing economic activity. higher than the level justified by productivity gains; and
2. Activists regard the self-correcting mechanism, which demand-pull inflation, which results when policymak-
works through wage and price adjustment, as very ers pursue high output and employment targets through
slow and hence feel that the government should pursue policies that increase aggregate demand. Both demand-
active, accommodating policy to address high unem- pull and cost-push inflation led to the Great Inflation
ployment when it develops. Nonactivists, by contrast, that occurred in the United States from 1965 to 1982.
believe that the self-correcting mechanism works 5. When the nominal policy rate hits the floor of the effec-
quickly and therefore advocate that the government tive lower bound, the aggregate demand curve becomes
should avoid the implementation of active policies upward-sloping, which means that the self-correcting
aimed at eliminating unemployment. mechanism that returns the economy to full employment
3. Milton Friedman’s view that in the long run inflation is is no longer operational. At the effective lower bound, in
always and everywhere a monetary phenomenon is borne order to boost output and inflation, the monetary author-
out by aggregate demand and supply analysis: Such ities must turn to nonconventional policies of three types:
analysis shows that monetary policymakers can target liquidity provision, asset purchases (typically referred to
any inflation rate in the long run through autonomous as quantitative easing), and management of expectations.
KEY TERMS
activists, p. 621 effectiveness lag, p. 622 legislative lag, p. 622
cost-push inflation, p. 625 implementation lag, p. 622 nonactivists, p. 621
data lag, p. 622 inflation gap, p. 615 recognition lag, p. 622
demand-pull inflation, p. 625 inflation target, p. 615
divine coincidence, p. 617 Keynesians, p. 621
QUESTIONS
1. You hear an analyst from Natixis say that the inflation c. Government spending increases in Pakistan.
gap is negative. What does it mean? d. Taxes increase in Italy.
2. How can the central bank eliminate both the output gap e. The domestic currency appreciates in the Eurozone.
and inflation gap in the short run?
4. During the global financial crisis, how was the Fed able
3. For each of the following shocks, describe how to help offset the sharp increase in financial frictions
monetary policymakers would respond (if at all) to without the option of lowering interest rates further?
stabilize economic activity. Assume the economy starts Did the Fed’s plan work?
at a long-run equilibrium.
5. Why does the divine coincidence simplify the job of
a. Consumers in China reduce autonomous policymakers?
consumption.
6. Why do negative supply shocks pose a dilemma for
b. Financial frictions decrease in Australia. policymakers?
7. Suppose three economies are hit with the same nega- discretionary policy to eliminate unemployment? Why
tive supply shock. In country A, inflation initially rises or why not?
and output falls; then inflation rises more and output 14. Why do activists believe that the economy’s self-
increases. In country B, inflation initially rises and out- correcting mechanism works slowly?
put falls; then both inflation and output fall. In country
15. You just read in an economics blog that the Japanese
C, inflation initially rises and output falls; then inflation
Yen is appreciating beyond its intrinsic value. How are
falls and output eventually increases. What type of sta-
policymakers likely to respond if this is true?
bilization approach did each country take?
16. Suppose one could measure the welfare gains derived
8. Suppose three economies are hit differently from the
from eliminating output (and unemployment)
coronavirus pandemic, but with the same negative
fluctuations in the economy. Assuming these gains
supply shock during 2020. In Chile, inflation initially
are relatively small for the average individual, how do
rises and output falls; then, inflation rises more and
you think this measurement would affect the activist/
output increases. In Paraguay, inflation initially rises
nonactivist debate?
and output falls, then both inflation and output fall. In
Colombia, inflation initially rises and output falls; then, 17. “The existence of long policy lags makes activism a very
inflation falls, and output eventually increases. What efficient way of adjusting the economy.” Is the state-
type of stabilization approach did each country take? ment correct?
9. The fact that it takes a long time for firms to get new 18. How can monetary authorities target any inflation rate
plants and equipment up and running is an illustration they wish?
of what policy problem? 19. What will happen if policymakers erroneously believe
10. In the United States, many observers have commented that the natural rate of unemployment is 7% when it is
in recent years on the “political gridlock in Washington, actually 5% and therefore pursue stabilization policy?
D.C.,” and referred to Congress as a “Do Nothing 20. Suppose that Banco Central do Brazil erroneously
Congress.” What type of policy lag is this describing? believes that the natural rate of unemployment is 9%
11. In Europe, many analysts criticized the deadlock in the EU when it is actually 7% and therefore pursue stabiliza-
parliament to approve the Pan-European Guarantee Fund tion policy?
to tackle the economic consequences of the COVID-19 21. How does the policy rate hitting a floor a little below
pandemic. What type of policy lag is this describing? zero lead to an upward-sloping aggregate demand curve?
12. “If the data and recognition lags could be reduced, 22. Why does the self-correcting mechanism stop working
activist policy probably would be more beneficial to the when the policy rate hits the effective lower bound?
economy.” Is this statement true, false, or uncertain? 23. In what ways can nonconventional monetary policy
Explain your answer. affect the real interest rate for investments when the
13. If the economy’s self-correcting mechanism works economy reaches the effective lower bound? How are
slowly, should the government necessarily pursue credit spreads affected?
APPLIED PROBLEMS
24. What nonconventional monetary policies shift the p
aggregate demand curve, and how do they work? LRAS
25. Suppose the current Italian administration decides to
decrease government expenditures as a means of cut- AS
ting the existing government budget deficit.
a. Using a graph of aggregate demand and supply, show pT
the effects of such a decision on the economy in the p2
short run. Describe the effects on inflation and output.
AD1
b. What will be the effect on the real interest rate, the
inflation rate, and the output level if the European AD2
Central Bank decides to stabilize the inflation rate?
Y2 YP Y
26. As monetary policymakers become more concerned a. How might fears of a zero lower bound justify such
with inflation stabilization, the slope of the aggregate a policy, even if the economy was not actually in a
demand curve becomes flatter. How does the resulting recession?
change in the slope of the aggregate demand curve b. Show the impact of these policies on the MP curve
help stabilize inflation when the economy is hit with and the AD/AS graph. Be sure to show the initial
a negative supply shock? How does this affect output? conditions in 2003 and the impact of the policy on
Use a graph of aggregate demand and supply to the deflation threat.
demonstrate.
28. Suppose that f is determined by two factors: financial
27. In 2011, as the Eurozone economy was coming from a panic and asset purchases.
low growth and inflation environment and the risk of
a. Using an MP curve and an AS/AD graph, show
a breakup in the Eurozone being discussed from many
how a sufficiently large financial panic can pull the
analysts, the ECB proactively lowered the deposit rate
economy below the effective lower bound and into a
from 0.75% in late 2011 to 0% by mid-2012. In addi-
destabilizing deflationary spiral.
tion, the ECB committed to keeping the deposit rate
at this level for a considerable period. This policy was b. Using an MP curve and an AS/AD graph, show how
considered highly expansionary and was seen by some a sufficient amount of asset purchases can reverse the
as potentially inflationary and unnecessary. effects of the financial panic depicted in part (a).
DATA ANALYSIS PROBLEMS

The Problems update with real-time data in MyLab Economics GDP estimate. Calculate the gap as the per-
and are available for practice or instructor assignment. centage deviation of output from the poten-
1. Real-time Data Analysis On January 28, 2019, the Fed- tial level of output. Calculate the average
eral Reserve released its amended statement on longer-run value over the most recent four quarters of
goals and monetary policy strategy. It stated: “The Commit- data available.
tee reaffirms its judgment that inflation at the rate of 2 per- c. For the most recent 12 months of data
cent, as measured by the annual change in the price index available, calculate the average unemploy-
for personal consumption expenditures, is most consistent ment gap, using 4.4% as the presumed
over the longer run with the Federal Reserve’s statutory natural rate of unemployment. Based on
mandate” and that “the median of FOMC participants’ esti- your answers to parts (a) through (c), does
mates of the longer-run normal rate of unemployment was the divine coincidence apply to the current
4.4 percent.” Assume this statement implies that the natural economic situation? Why or why not? What
rate of unemployment is believed to be 4.4%. Go to the St. does your answer imply about the sources
Louis Federal Reserve FRED database, and find data on the of shocks that have impacted the current
personal consumption expenditure price index (PCECTPI), economy? Briefly explain.
the unemployment rate (UNRATE), real GDP (GDPC1), 2. Real-time Data Analysis Go to the St. Louis Federal
and real potential gross domestic product (GDPPOT), an Reserve FRED database, and find data on the personal con-
estimate of potential GDP. For the price index, adjust the sumption expenditure price index (PCECTPI), the unem-
units setting to “Percent Change From Year Ago.” Down- ployment rate (UNRATE), and an estimate of the natural
load the data into a spreadsheet. rate of unemployment (NROU). For the price index, adjust
a. For the most recent four quarters of data the units setting to “Percent Change From Year Ago.” For
available, calculate the average inflation gap the unemployment rate, adjust the frequency setting to
using the 2% target referenced by the Fed. “Quarterly.” Select the data from 2000 through the most
Calculate this value as the average of the current data available, download the data, and plot all three
inflation gaps over the four quarters. variables on the same graph. Using your graph, identify
b. For the most recent four quarters of data periods of demand-pull or cost-push movements in the
available, calculate the average output gap inflation rate. Briefly explain your reasoning.
using the GDP measure and the potential

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Learning Objectives

24.1 Illustrate and Preview

Response to an Aggregate Demand Shock

Step 3. the economy AD1

FIGURE 1 Aggregate Demand Shock: No Policy Response

Response to a Supply Shock

Step 3. Autonomous easing of monetary

No Policy Response One potential policy choice is to refrain from making an

Step 3. Inﬂation and economic

FIGURE 3 Response to a Supply Shock: No Policy Response

Step 1. A negative supply

2 Step 3. The short-run

Step 4. leading policymakers to Y3 Y2 Y P = 100

FIGURE 4 Response to a Supply Shock: Short-Run Inflation Stabilization

The Bottom Line: The Relationship Between Stabilizing

Inﬂation Step 4. Output has stabilized LRAS

p3 3 Step 1. A negative supply

FIGURE 5 Response to a Supply Shock: Short-Run Output Stabilization

24.2 HOW ACTIVELY SHOULD POLICYMAKERS TRY

Lags and Policy Implementation

24.3 INFLATION: ALWAYS AND EVERYWHERE A MONETARY

FIGURE 6 A Rise in the Inflation Target

The analysis in Figure 6 demonstrates the following key points:

24.4 CAUSES OF INFLATIONARY MONETARY POLICY

High Employment Targets and Inflation

Cost-Push Inflation Consider the economy shown in Figure 7, which is initially

Step 4. leading to a Step 1. A negative supply shock

Step 2. causing output to fall Y' Y P = 100

FIGURE 7 Cost-Push Inflation

Demand-Pull Inflation A goal of high employment can lead to inflationary fis-

Step 3. leading to a Step 2. causing the short-run aggregate

FIGURE 8 Demand-Pull Inflation

Cost-Push Versus Demand-Pull Inflation When inflation occurs, how do

A P P L I C AT I O N The Great Inflation

Panel (a) Inﬂation, 1965–1982

Panel (b) Unemployment and the Natural Rate of Unemployment, 1965–1982

Step 3. Unemployment was

2% Step 1. Unemployment was

Natural Rate of Unemployment Unemployment Rate

FIGURE 9 Inflation and Unemployment, 1965–1982

24.5 MONETARY POLICY AT THE EFFECTIVE LOWER BOUND

Deriving the Aggregate Demand Curve with the

Panel (a): MP Curve

Panel (b): Aggregate Demand Curve

Step 4. but has an upward

The Disappearance of the Self-Correcting Mechanism

A P P L I C AT I O N Nonconventional Monetary Policy

FIGURE 12 Response to Nonconventional Monetary Policy

Asset Purchases and Quantitative Easing

A P P L I C AT I O N Abenomics and the Shift in Japanese

FIGURE 13 Response to a Rise in Inflation Expectations

Step 1. Asset purchases lower f

p2 AS1 Step 3. increasing

FIGURE 14 Response to the Shift in Japanese Monetary Policy in 2013

DATA ANALYSIS PROBLEMS

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