MONETARY POLICY (PART

3)
Chapter 14

MONETARY POLICY AND THE

ACTIVISTNONACTIVIST DEBATE
Activists argue that
monetary and fiscal
policies should be
deliberately used to
smooth out the
business cycle.
They are in favor of
economic fine-tuning,
which is the frequent
use of monetary and
fiscal policies to
counteract even small
undesirable movements
in economic activity.

Nonactivists argue
against the use of
deliberate fiscal and
monetary policies.
They believe the
discretionary policies
should be replaced by a
stable and permanent
monetary and fiscal
framework and the rules
should be established in
place of activist policies.

THE CASE FOR ACTIVIST MONETARY

POLICY
1.

2.

3.

The economy does not always equilibrate quickly

enough at Natural Real GDP. Without intervention,
the economy will stuck at a recessionary gap for too long,
resulting in the economy having to tolerate too much loss
in output and high unemployment in the interim.
Activist monetary policy works; it is effective at
smoothing out the business cycle. Data of 1970s
indicates periods of constant money supply growth being
consistent with recession during the same time. Activists
argue this could have been avoided with discretionary
monetary policy.
Activist monetary policy is flexible; non-activist
monetary policy, which is based on rules, is not.
Activist monetary policy can be tailored to meet the
demand of an economy, unlike a rule-based policy.

THE CASE FOR NON-ACTIVIST

MONETARY POLICY
1.

2.
3.

In modern economies, wages and prices

are sufficiently flexible to allow the
economy to equilibrate at reasonable
speed at Natural Real GDP.
Activist monetary policies may not work.
Activist monetary policies are likely to
be destabilizing rather than stabilizing;
they are likely to make matters worse
rather than better.

EXPANSIONARY MONETARY POLICY

AND NO CHANGE IN THE REAL GDP
If expansionary
monetary policy is
anticipated, workers
may bargain for and
receive higher wage
rates. It is possible
that the SRAS curve
will shift leftward to
the degree that
expansionary
monetary policy shifts
the AD curve
rightward. Result: no
change in Real GDP.

MONETARY POLICY MAY

DESTABILIZE THE ECONOMY
In this scenario, the
SRAS curve is shifting
rightward, but Fed
officials do not realize
this is happening. They
implement expansionary
monetary policy, and the
AD curve ends up
intersecting SRAS2 at
point 2 instead of SRAS1
at point 1. Fed officials
end up moving the
economy into an
inflationary gap and
thus destabilizing the
economy

NON ACTIVIST MONETARY

PROPOSALS
Non-Activists propose the following non-activist (or
rule-based) monetary proposals:
1.
2.
3.
4.

Constant-money-growth-rate rule
Predetermined-money-growth-rate rule
The Taylor Rule
Inflation Targeting

CONSTANT MONEY - GROWTH

RATE RULE
The annual money supply growth rate will be constant
at the average annual growth rate of the Real GDP.
Aim: To stabilize the price level.
Setting the annual growth rate of Money Supply
equal to the average annual growth rate of Real GDP.
This is based of MV PQ.
If M and Q is increased at the same rate, and V is
assumed constant, than price level will remain the
same.
In some years the actual growth rate of GDP will be
able its average (price level will increase), in other
years, vice versa. Overtime, price level will be stable.

PREDETERMINED-MONEY-GROWTHRATE RULE
The annual growth rate in the money supply will be
equal to the average annual growth rate in Real
GDP minus the growth rate in velocity.
Aim: To stabilize the price level.
Constant-money-growth-rate rule assumes
velocity to be constant and unclear about which
definition of money supply to use.
Set %M = %Q - %V
Using MV PQ, %M + %V = %P + %Q
Setting it this way will ensure price level remains
stable.

THE FED AND THE TAYLOR RULE

The Taylor Rule provides a middle ground for Activists
and Non-Activists policy.
Aim: To find a federal funds rate that is consistent
with(1) Stabilizing inflation around the targeting low
inflation rate (3) Stabilizing Real GDP around its fullemployment level.

The Fed should find this rate and use their tools to
achieve this.
Federal Funds rate target = Inflation + Equilibrium
real federal funds rate + (1/2)Inflation Gap +
(1/2)Output Gap

INFLATION TARGETING
Inflation Targeting: Targeting that requires the
Fed to keep the inflation rate near a predetermined
level.
Issues:
1. Whether inflation rate should be a particular
rate or range?
2. What should this rate or range be?
3. Should this be disclosed to the public?

INFLATION TARGETING
For an inflation rate target approach, the Fed
would simply undertake monetary policy actions to
keep or at its target.

The proponents of inflation targeting argue that

such a policy is more in line with the Feds
objective of maintaining near price stability.
The critics argue that such a policy will constrain
the Fed during times of financial crisis, which it
is required that the target be ignored.