Quiz 17: Monetary Policy: Goals and Tradeoffs


The main goal of stabilization policy is to smooth out the business cycle, reducing output during economic expansions and increasing output during recessions. If the Fed were able to use stabilization policy to perfectly smooth out the business cycle, then output would line-up with its trend and the business cycle would be eliminated. However, most likely the cycle can be smoothed only imperfectly. With stabilizing policy, recessions would not be as deep, output would not decline as much, and the unemployment rate would not rise as high as it would with neutral policy. With stabilizing policy expansions would not be as strong, output would not rise as much, and inflation would not increase as high as it would with neutral policy. This result is achievable if the private sector has difficulty adjusting to changes in the growth rate of output. In that case, in the face of some shock to the economy, the Fed may be able to use monetary policy to offset the shock because the private sector is not very adaptable.

The Fed uses the monetary policy as a tool to correct any imbalances that arises in the economy. This is sometimes called the stabilization policy. The main objective is to keep the GDP growth close to its trend line. This will eliminate the business cycle and thus the recession. However, it is only theoretically possible. If the Fed can achieve the right monetary policy it can eliminate the business cycle. However, the monetary policy can be destabilizing in marginal cases. This can occur due to the various lags that associated with the monetary policy. Due to the policy lags the monetary policy can be implemented at the wrong time. That is, it might happen that the Fed takes a tighter policy in the time of recession. This leads to a situation called destabilization policy. In this situation, the fall of output is greater in the recession than it would have been under neutral policy.

The Fed uses monetary policy to achieve three major goals: maximize output, decreasing unemployment, and stabilizing inflation rate. In case of affecting the output, the Fed can influence it in the short run but it depends on many other factors such as total factor productivity and growth in labor force. The output growth was stable during 60s, 70s, and 80s. The biggest fall in output is marked by the 2008 recession. The next goal of the Fed is to keep unemployment rate low. The unemployment rate is correlated with the output growth, higher the output growth, lower the unemployment rate. However, even if the economy produces the potential output the unemployment rate remains low but never eliminated. The unemployment rate that exists when the economy performs at potential output is called the natural rate of employment. The Fed policy target is to keep unemployment as close to natural rate as possible. Over the last 20 years, the largest increase in unemployment rate was during 2008 recession and it went below 4% (lowest in past 30 years) in 1980s. The third and trickiest was targeting inflation rate. However, as output and unemployment rate, the Fed cannot solely affect the inflation rate. The inflation can be measured in many different ways, among which the CPI index excluding food and energy prices is a useful indicator of the inflation. In past 20 years, the inflation rate was steady at 2%. The Fed took special care about inflation because it redistribute wealth between borrower and lender, it affect many economic decision including wage negotiation and investment.