There are two ways in which a negative supply shock can lead to an inappropriate central bank policy:

1. A negative supply shock makes the economy less productive, causing the level of national output/income to fall, even if the level of unemployment does not change. If the government does not recognize this fact and thinks instead that the decrease in income reflects a cyclical downturn, it may use monetary policy to stimulate the economy. The policy of targeting on the income level would then create a situation very similar to that described earlier for targeting on the unemployment rate. Stimulation will be successful in the short run but not in the longer run because the situation will require further stimulation and an acceleration of inflation will take place. By targeting on the pre-supply-shock level of output, the central bank could lose control of the money supply.

2. A negative supply shock decreases the productivity of labor. Firms cannot afford to hire as many workers at the prevailing real wage, so unemployment develops unless the real wage falls to reflect the lower productivity of labor. If the real wage is prevented from falling—by strong labor unions, for example, or a national labor contract expressed in real terms—the economy will become stuck at a level of unemployment above the natural rate. The central bank could misread this unemployment level as a cyclical phenomenon and adopt a stimulating dose of monetary policy. The result is similar to that given earlier for targeting on an underestimate of the NRU. As long as the real wage is artificially held too high, this policy will accelerate the inflation. By targeting on the pre-supply-shock unemployment rate the central bank could lose control of the money supply.

Suppose the central bank has chosen to target monetary policy on the NRU, so that whenever unemployment departs from its natural rate, monetary policy reacts by pushing it back. A problem with this approach is that the NRU is never known. It must be estimated, and it can easily be underestimated. One reason for underestimation is that many politicians find it difficult to believe that the natural rate can be so high and, consequently, continually bring pressure to bear on the central bank to lower unemployment.

Suppose the economy is at the NRU, but the central bank does not realize that it is and thinks that the NRU is lower. An expansionary monetary policy will be undertaken to push down unemployment, creating some unexpected inflation. The unexpected inflation causes the real wage to fall, either because workers are slow to realize what has happened or because of contract obligation s that prevent immediate adjustment of wages. The fall in the real wage induces firms to increase output. After a time, however, inflation expectations increase and contracts are renegotiated, restoring the real wage to its original level and moving the economy back to the true natural rate. This situation prompts the central bank to increase its stimulation in order to keep the economy below the NRU, thereby accelerating the inflationary forces and causing this process to be repeated. The economy is prevented from moving back to its actual NRU, but at a cost of an accelerating inflation. By targeting on an underestimate of the NRU, the central bank could lose control of the money supply.

The Phillips curve can be used to create some explanations for stagflation, which can be defined as high inflation combined with high unemployment, or as rising inflation in conjunction with rising unemployment. In the world of the original Phillips curve, both such phenomena were impossible.

Consider first stagflation defined as high inflation combined with high unemployment. High inflation can be created by a high money-supply growth rate. There are three basic ways in which high unemployment can accompany this high inflation:

1. High NRU. The natural rate of unemployment may itself be high, owing to factors affecting frictional or structural unemployment, or for institutional reasons such as generous unemployment insurance benefits.

2. A current fight against inflation: The government may be in the process of fighting an inflation by creating a recession, so that the economy is temporarily lodged near a point like E in figure 12.3.

3. Real wage overhang. A permanent negative supply shock may have occurred, and workers may refuse to allow their real wage to fall. If they have sufficient power or a wage indexation policy to hold their real wage up, unemployment beyond the natural rate will develop. Consider now stagflation defined as rising inflation in conjunction with rising unemployment. There are several ways in which these things can happen at the same time:

1. An increase in money growth. The dynamic reaction of the economy to an increase in the rate of money-supply growth is such that, in its later stages, inflation and unemployment increase together, as illustrated by the path from point C to D in figure 12.2.

2. A supply shock. A negative supply shock raises costs, causing producers to raise prices. The higher prices lower aggregate demand, so output and employment fall.

3. Labor hoarding. As an economy moves into recession and unemployment rises, firms tend to keep on some redundant employees (in order to keep trained labor available for the end of the recession). This policy raises per-unit costs, requiring higher markups to maintain profitability. The lower output level also implies a loss of economies of scale, also raising per-unit costs.

4. Participation rate changes. A rise in inflation often occurs when employment is rising. It is possible that discouraged workers may rejoin the labor force if they see employment rising, and the measured level of unemployment rises as a result.

5. Inflation variability. When inflation is higher, its rate is more variable, increasing uncertainty in economic markets. Firms react by investing less, thus decreasing economic growth.

A major reason why lowering inflation requires a prolonged recession is the coordination problem: people will not moderate wage and price increases until everyone else does. A wage-price control policy, such as that imposed by President Nixon in 1971, puts legal constraints on wage and price increases. Controls policies and their variants, such as wage-price guidelines with no formal legal penalties, or guidelines with a tax on excessive wage or price increases, are called incomes policies. An incomes policy imposes the missing coordination and, by doing so, allows the economy to move quickly down the long-run Phillips curve, thus avoiding the high cost of a prolonged recession. This is the benefit of a policy of wage-price controls.

Most economists do not look upon wage-price controls with favor, for two reasons:

1. Complementary monetary and fiscal policy are required. Most empirical evidence suggests that control policies do not work, even if, as was done by Diocletian during the Roman Empire, the death penalty is imposed for violation. This evidence, however, comes from situations in which the control policies could not have been expected to be successful. If the rate of growth of the money supply were not reduced from 5 percent to 3 percent, it would be impossible for a policy of wage-price controls to be successful. Some evidence, such as the 1975-78 Canadian experience, suggests that control policies can be of benefit if they are complemented by appropriate monetary and fiscal policies—a crucial proviso to the adoption of wage-price control policies.

2. Costs and benefits should be compared. There are high costs associated with controls. The most important costs result from the constraints that controls place upon the operation of the price system, hindering its job of allocating and distributing goods and services in an efficient fashion. These costs could be considerable, but can be alleviated somewhat by designing some flexibilities into the controls program. For example, the controls rules could permit extra wage or price increases in markets experiencing obvious shortages. In any event, a decision to adopt or reject a guidelines or controls program should be made by comparing its costs and benefits.

Because it is a key ingredient in explaining such a wide variety of media commentary, the distinction between real and nominal interest rates is the most important macroeconomic concept introduced in this book. There are eight general types of applications to note.

1. Definitional interpretation. Some applications merely require knowledge of the difference between real and nominal interest rates and the fact that it is the real interest rate that affects spending:

Moreover, contrary to the central bank’s pronouncements, higher interest rates have not caused everyone to borrow less. Most people are borrowing as much as ever—or more—to buy goods now.

In this case, the higher interest rate must be a higher nominal interest rate but a lower real interest rate because of high inflation expectations.

2. Forecasting interest rates. Substantive changes in the nominal interest rate are usually due more to changes in expected inflation than to changes in the real interest rate:

Corporate treasurers should not be frightened by the recent rise in interest rates on bonds. Rates of even 13 percent will look like bargains if inflation heats up over the next 18 months.

A corporate treasurer deciding when is the best time to issue his or her corporation’s bonds must pay close attention to inflation expectations.

3. The interest rate as a monetary policy indicator. Equating high interest rates with tight monetary policy is a recipe for disaster in an inflationary environment. The high interest rate could be a high nominal rate but a low real rate, and so be a misleading guide to the true stance of monetary policy. An example is the following, discussed earlier as example 4 in the media illustrations section of this chapter.

Although interest rates were for many years the main policy indicator used by most central banks, the experience with severe inflation beginning in the 1970s made it clear they were fickle guides for the task of ensuring that monetary policy was directed toward price stability.

4. The influence of expected inflation on the bond market. Millions of dollars are made and lost on the bond market daily, due to fluctuating nominal interest rates:

A smaller-than-expected decrease in the U.S. money supply dealt the North American capital market a hard blow, as bond prices sagged across a broad front.

This is a typical news report emphasizing that inflation expectations are strongly influenced by money growth figures. In this case, because the decrease was smaller than expected, inflation expectations were revised upward, raising the nominal interest rate and lowering bond prices.

5. How economic news affects the bond market. An apparent oddity in the real word is the fact that bad economic news (higher unemployment, for example) is interpreted as good news for bond markets, causing the bond market to surge, and good economic news causes the bond market to fall. This phenomenon can be explained by analyzing the influence of this news on the nominal interest rate, either by appealing to the impact of this information on expected inflation, or by introducing expectations of a central bank reaction to influence the real interest rate. Consider the following example:

Bonds rallied sharply yesterday, cheered on by the news that the recession isn’t over yet. Prices climbed by as much as $8.75 for each $1,000 face amount in the U.S. government securities market after the Commerce Department reported that GDP fell by 0.1 percent in the second quarter

This news clip reports a typical reaction to information released monthly regarding employment or quarterly regarding GDP. Continued recession reduces fears of inflation. This reduced concern lowers inflation expectations, thereby lowering the nominal interest rates and raising bond prices. Alternatively, continued recession may cause people to believe that the Fed wilt stimulate the economy by lowering interest rates.

6. Central bank control of the interest rate. The Fed’s ability to manipulate the interest rate is limited. Although it may have considerable control in the short run, in the longer run inflation expectations play a prominent role. An example is the following, discussed earlier as example 3 in the media illustrations section of this chapter.

The Fed chairman added that the principal misunderstanding about the Fed’s role in the present situation is that it could achieve more or less immediately a low level of interest rates if it wanted to.

7. Equivocal impact of monetary policy. In the absence of changes in inflation expectations, an increase in the money supply lowers the interest rate. But an increase in the money supply when the economy is near full employment could be interpreted as creating inflation, increasing inflation expectations, reversing this fall in the nominal interest rate. Higher inflation expectations could also be triggered by fears that an unexpected increase in the money supply reflects a higher money growth rate. Consider the following example:

This brings us back to the fears of higher interest rates before the market break. These fears are still potent, especially if investors see through the temporary reduction in interest rates made possible by stepping up the rate of creation of the money supply.

This clip shows how changes in inflation expectations can offset the usual downward impact on the interest rate of a higher money supply, rendering it only temporary.

8. Explaining international interest-rate differences. As will be seen in chapter 18, real interest rates are roughly equal across countries. Nominal interest rates, however, can differ substantially:

Prior to 1989 it was widely believed that New Zealand 10-year government bond interest rates could not fall below those of Australia. Once NZ rates fell below those of Australia the view on relative rates changed to one where NZ rates could not fall below those of the United States due to the high liquidity of the U.S. bond market. But this also has been proved wrong.

This clip is particularly interesting because it points to a phenomenon that is easily explained by macroeconcmic theory but that apparently was not well understood by observers. In this case, New Zealand inflation has fallen relative to Australian and U.S. inflation, by enough to cause its nominal interest rate to fall below Australian and U.S. interest rates.

The view of discretionary monetary policy that has emerged from this chapter and the preceding two chapters is that through open-market operations the central bank can stimulate the economy by increasing the money supply, alternatively viewed as pushing down the interest rate. In a longer-run context an eye must be kept on the rate of growth of the money supply to ensure that inflation is not allowed to escalate, but in a noninflationary environment, discretionary use of monetary policy is a useful alternative or supplement to fiscal policy.

Both fiscal and monetary policy shift the AD curve in the aggregate-supply/aggregate-demand diagram. Fiscal policy changes aggregate demand directly; monetary policy changes aggregate demand by changing the interest rate. Two marked differences between monetary and fiscal policy, however, should be noted.

1. Timing considerations. Monetary policy can be implemented much more quickly than fiscal policy, since it does not require congressional approval. Once implemented, however, it affects the economy more slowly than fiscal policy because it takes time for decision makers to react to lower interest rates. It has been estimated, for example, that only about one-third of the impact of an interest rate change on aggregate demand occurs within one year, and only about one-half within two years. Furthermore, these lags are variable as well as long, making it quite difficult for monetary authorities to deduce the correct timing for monetary policy. Therefore, any temporary, discretionary, diversion from the monetarist rule must be undertaken with great care.

2. Discrimination considerations. Monetary policy affects the economy very broadly, allowing the impersonal forces of supply and demand to distribute its impact efficiently across the economy. Fiscal policy has this effect when it takes the form of tax changes, but not when it takes the form of government spending changes; the discriminatory effects of government spending could be either an advantage in that the spending could be directed at a depressed region or a disadvantage in that it may be directed by political whims. Despite the impersonality of monetary policy, however, it is discriminatory. The components of aggregate demand that are more sensitive to interest-rate changes bear the costs of adjustment. The sector most strongly affected in this regard is the housing sector, which is notoriously sensitive to interest-rate changes. A fall in the mortgage rate from 10 percent to 8 percent, for example, decreases the monthly payment on a 30-year mortgage by more than 16 percent. This saving markedly increases the demand for residential construction. The export- and import-competing sectors are also strongly affected. Interest-rate changes cause foreigners to change their demand for our currency to invest in our financial assets, altering the exchange rate and affecting the profitability of business in the international sector.

Our discussion of monetary policy is not yet complete. The next chapter examines its role in an inflationary environment, providing further insight into the relationship between monetary policy and interest rates. Chapter 16 looks at how monetary policy is affected by international influences.

The inverse relationship between the interest rate and the price of bonds is fundamental to understanding how monetary policy affects interest rates and why people in the financial world are always so worried about the future course of the interest rate. This inverse relationship is illustrated for the two main types of bonds—coupon bonds and discount bonds.

A coupon bond pays the owner of the bond a fixed interest payment each year until the bond matures when the face value (or par value) of the bond is paid. The name “coupon bond” comes from the fact that, until recently, the bond owner had to clip a coupon from the bottom of the bond each year to receive this fixed interest payment. Now these payments are made electronically.

Suppose you own a coupon bond that is due to mature in five years, with face value $1,000 and coupon $100. If the interest rate is 10 percent, the current price of this bond should be $1,000 because the $100 interest coupon payment is 10 percent of the price of the bond. Now suppose the interest rate rises to 12 percent. Seeing this increase, you decide to sell your bond and use the proceeds to buy a new bond that pays 12 percent. Unfortunately for you, however, nobody will be willing to pay $1,000 for your bond because everyone knows he or she can earn a 12 percent return elsewhere. To sell your bond you will have to lower its price, in this case to $833.33 because at this price the $100 interest payment is a return of 12 percent.

Actually, the price will not fall quite this far. Because the bond will pay off at $1,000 in five years, the total return to investing in this bond is the stream of five $100 interest payments, plus a capital gain due to the rise in bond price to $1,000 over these five years. The yield to maturity, which is what economists mean by an interest rate, would be higher than 12 percent. For the yield to maturity to be 12 percent, the price need only fall to $927.90. For those interested, this calculation is explained in appendix 10.1.

An opposite result would occur if the interest rate were to fall to 8 percent. Everyone would want to buy your bond if it were priced at $1,000, because the 10 percent return on your bond would be higher than the 8 percent return available elsewhere. As a result, potential buyers would bid up the price of your bond in their efforts to obtain it, in this case to $1,250 because the $100 return is 8 percent of $1,250. Once again, this is not quite correct. In five years this bond will pay off at $1,000, so holders will experience a capital loss if they buy it for a higher price, implying that the yield to maturity is lower than 8 percent. The price will be bid up to only $1,079.85.

A discount bond is a bond without a coupon (and is therefore sometimes called a zero-coupon bond). The return to holding such a bond comes entirely from buying it at a price below its face value. The most common example is a U.S. government Treasury bill, called a T-bill, sold originally at weekly auctions for maturity periods of three months, six months, and a year (and then, like all other bonds, available for resale on the regular money market). If the interest rate is 10 percent, the price for a one-year $10,000 T-bill will be $9,090.91 since the return of $10,000 - $9,090.91 = $909.09 is 10 percent of the $9,090.91 price paid.

If the interest rate were higher, say 12 percent, the price of the T-bill would be lower—in this case $8,928.57—to make the return of $10,000 - $8,928.57 = $1,071.43 be 12 percent of the $8,928.57 purchase price. If the interest rate were lower, say 8 percent, the price of the T-bill would be higher, in this case $9,259.26.

Regardless of the type of bond, there is an inverse relationship between interest rates and bond prices. This relationship is as close to a true economic law as it can get: interest rates and bond prices are instantly connected, with the causal force going in either direction. If someone decides to sell a bond, for whatever reason, and drops the bond price to sell it, the interest rate instantly rises. And if the interest rate rises, for whatever reason, the market reacts instantly to push down bond prices.

It should now be evident why this relationship between interest rates and bond prices is so important. A change in the interest rate, which happens on a daily basis, can create substantial capital gains or losses for those holding bonds, particularly for those holding long-term bonds. It is for this reason that the financial pages of newspapers provide so much commentary on the future course of the interest rate.

Why are the capital gains and losses greater for longer-maturity bonds? Let’s look at the earlier example of a $1,000 face-value coupon bond with coupon $100 and time to maturity five years. A rise in the interest rate to 12 percent dropped the bond price to $927.90. Suppose there had only been one year to maturity; then the price would have fallen to $982.14. Someone buying this bond would, during the remaining year of its life, receive the $100 coupon plus that year’s capital gain, $17.86, generating a 12 percent return on outlay. If there had been five years to maturity, however, there would have to be five such annual capital gains as the bond price crawls up to its face value over the five years. Consequently, the price must fall further for a longer maturity bond. Capital losses and gains are much larger on long-term bonds than on short-term bonds.

Macroeconomists talk of “the” interest rate, but in fact a myriad of interest rates exist, depending on such variables as time to maturity of the financial asset, how the interest is taxed, how liquid the financial asset is, and what is known about the borrower (in particular, the risk of default). Short-term debt instruments, of maturity less than a year, are traded in what is called the money market. Longer-term instruments are traded in the capital market.

Typical interest rates in the money market are T-bill rates (on U.S. government Treasury bills); commercial paper rates (on loans by financial institutions to large banks and corporations); the federal funds rate (on very short-term loans between banks of their deposits at the Fed); and the Eurodollar rate (on U.S. dollars deposited outside the United States). Typical interest rates in the capital market are the mortgage rate, the corporate bond rate, the Treasury bond rate, and the municipal bond rate.

All these interest rates tend to move together, however, so little harm is done by analyzing the economy in terms of a single representative interest rate, as we do throughout the rest of this book. For those interested, the “Currency Trading” column in the “Money & Investing” section of the Wall Street Journal lists several key U.S. and foreign interest rates in about 20 categories.

Monetarists advocate their rule for several reasons:

1. It guarantees a low long-run rate of inflation. This creates a stable economic environment conducive to long-term investment projects, a necessary ingredient in the promotion of long-term growth.

2. It creates automatic stabilizing forces. As the economy moves into recession, income and thus the demand for money grow more slowly. If money-supply growth is kept steady, the slowdown in money-demand growth causes an excess money supply that begins to stimulate the economy and pushes it out of recession. If the economy overheats and begins to experience high inflation, the higher prices increase the demand for money, and an excess demand for money develops. This cuts back aggregate demand (as people stop spending to accumulate more money), which puts a damper on the inflationary forces.

3. It insulates monetary policy from politics. Just before an election, politicians are tempted to pump up the money supply, letting the later fallout of higher inflation appear after the election.

4. It prevents the Fed from making mistakes. History has shown that the Fed makes many mistakes in its efforts to use discretionary monetary policy to improve the economy. Although major mistakes—such as its failure to serve as a lender of last resort during the Great Depression and its overly expansionary monetary policy during the Vietnam war—have become less and less frequent over time as the Fed has learned, monetarists argue that even a clever and well-intentioned Fed is doomed to make mistakes continually because of the extreme complexity of the economy. For example, the magnitude of the income multiplier with respect to the money supply is uncertain and changing; the lags of monetary policy in affecting the economy are long, variable, and unpredictable; and forecasting the economy’s behavior is difficult.

However, those who believe in the use of discretionary monetary policy offer cogent criticisms of this monetarist prescription:

1. Unstable velocity. Although most economists concur with the general logic of the inflation equation, they note that to make it operational, a specific measure of the money supply must be chosen—in particular one for which velocity is constant, or at least growing at a constant rate. As a result of banking innovations and financial deregulations, M1 velocity and, to a lesser extent, M2 velocity have behaved irregularly at times, as illustrated in figure 9.4. This objection is summarized in amusing fashion by Goodhart’s law: what ever measure of the motley supply is chosen for application of the monetarist rule, it will soon begin to misbehave. It will no longer bear a stable relationship with income or inflation. One suggestion for overcoming this drawback is to change the rule to target on a nominal GDP growth rate equal approximately to the historical real rate of growth of GDP. When nominal GDP grows faster than the chosen target rate, cut back on money-supply growth; when nominal GDP grows more slowly than the target rate, increase money-supply growth. Changes in velocity cause changes in nominal GDP, so they are automatically offset by this rule.

2. Lack of Fed control over money supply. Even if velocity were constant, the Fed could not maintain close enough control over the money supply to effect the monetarist rule. This lack of control arises from several sources: the public’s holdings of currency fluctuate irregularly; banks and the public shift deposits from one measure of the money supply to another; financial innovations are continually rendering money measures obsolete; banks can choose to hold excess reserves; and banks can obtain extra reserves if needed by borrowing cheaply from the Fed. Unstable velocity and the lack of control over monetary aggregates have prompted suggestions that it is better to target monetary policy directly on the inflation rate, rather than on a monetary aggregate.

The essence of the story presented in figure 9.1 is that an increase in the money supply causes changes in the economy that increase the demand for money to equal the now higher supply of money. In the new equilibrium, the change in the demand for money must equal the change in the supply of money. In the modern quantity theory the demand for money is given by (1/v)PQ, so there are three possible sources of change in demand for money—namely, changes in v, P, and Q. The preceding exposition assumed that v and P were constant so that a change in M elicited an equal percentage change in real income Q.

If the economy is at full employment, real income does not change; instead, the extra money supply causes an increase in the price level. To be specific, if the money supply increases by 8 percent when the economy is at full employment, prices increase by 8 percent to increase the demand for money to its higher supply. If the monetary authorities adopt a policy of increasing the money supply at a rate of 8 percent per year, an inflation of 8 percent per year develops, reflecting the adage that inflation is caused by too much money chasing too few goods.

This result is too crude, however, because it does not recognize that the full-employment level of income in the economy is growing due to population changes and investment that augments the nation’s capital stock. Suppose the economy’s real income growth rate is 2 percent per year. This 2 percent real growth in income causes the demand for money to increase by 2 percent per year. If the money supply is growing at 8 percent per year, then prices will increase by only 6 percent per year because 2 percent of the extra money supply is needed by the increasing real income. Only money-supply growth rates in excess of the rate of real income growth of the economy should create inflation.

This relationship is illustrated in Figure 9.2 where money growth is represented by the height of the left-hand rectangle; for equilibrium in the monetary sector, money-demand growth, represented by the height of the right-hand rectangle, must match money-supply growth. Some money-demand growth comes from the annual increase in real income; the rest must come from price increases—inflation.