Article review
Article review
Introduction
Government interference play huge role in the economic processes: by conducting monetary or fiscal policy, policymakers are able to stimulate the economy during the periods of downturn and moderate too fast growth during the periods of economic boom: both these cases have devastating consequences for the general growth and development. Particularly, central banks, that make decisions regarding the monetary policy, are most important players. By using different tools, such as interest rates, open market operations, required reserves etc., central banks might influence on aggregate supply and aggregate demand, thus shifting equilibrium to the desired level (in other words, to the desired levels of macroeconomic indicators, e.g. output, the inflation or unemployment rate). Actually, these tools are more precise and quick than the fiscal policy tools, and the more developed financial markets, the more efficient monetary policy is. With no doubt, one of the most influential and independent central banks in the world is the Fed. However, in recent years researchers are raising concerns regarding the Fed ability to mitigate efficiently undesirable economic events. For example, recent article by professor of Michigan University, Justin Wolfers, discusses several issues regarding the monetary policy, including the inability to use interest rate as the rate tend to zero, political independence of the Fed, role of expectations in the financial markets etc. Thus, the aim of this paper is to analyze the article and related issues applying main macroeconomic models and discussing the importance of conducting long-term oriented monetary policy.
Summary of the article
Discussing the recent job report, the author points out on the slowing down the employment rate growth. The possible reasons of such decrease are different: this economy might tend to the sustainable growth, or conversely this is beginning of slowdown, or reaction on political (coming elections) and external (the global slowdown and volatility) events. Whatever the reason, the author is concerned that the Fed is less prepared to respond to drastic events than ever before. This conclusion is based on the following arguments:
The main tool – interest rates, could no longer be used, because the rate is already too low.
Fiscal stimulation is too long to make significant effect on the economy, because this is always a gap between recognizing recession, then undertaking necessary measures and expecting the first results, considering that new administration will take office only in the beginning of the next year. Moreover, the tax policy priorities of the future administration are hard to predict before the elections.
Though the Fed is one of the most independent central banks in the world, it should consider political situation while making monetary policy decisions: therefore, the Fed would unlikely to change policy just before elections towards the quantitative easing.
The situation is worsening by expectation on the financial markets: the lack of confidence in timely response from authorities makes the economy more vulnerable and volatile.
Thus, the main conclusion made by the author is that the Fed is not prepared to possible negative economic events, that might occur unexpectedly, and that the monetary policy should be long-term oriented and prepared to “tomorrow failures”.
Opinion regarding the article
The concerns, expressed in the article are likely to be overestimated. As the previous experience during the Great Recession had shown that, the monetary and fiscal policy measures helped to stabilize the price level and the economic growth relatively fast. However, the decrease in the unemployment rate was not as optimistic, but whether the US unemployment is cyclical rather than structural is still debatable question. Therefore, though inflation targeting has some disadvantages, the Fed policy seemed to be effective in the recent years. This policy and following the Taylor rule helps to avoid time inconsistency problem and makes the Fed decisions less political than the author has claimed. Thus, the price stability is likely to remain the main priority of the Fed.
Macroeconomic analysis of the article
Moreover, the author highlights the importance of long-term oriented policy, in other words, policy makers should be prepared for the possible future drastic events. However, the macroeconomic analysis shows that monetary policy, conversely, is effective only in the short-run period. This could be explained by vertical slope of the long term aggregate supply curve (See Fig. 1).
For example, increase in money supply (expansionary monetary policy) shifts AD curve to the right thus reaching the output more than potential level (point B) . As costs are higher now, short-term aggregate supply curve would shift to the left – back to the natural level of output. Thus, in the long run the level of output remains the same, but the price level increases (from P1 to P2) and the monetary policy is neutral. The long run output might be driven by other factors, such as technological changes or natural rate of unemployment.
Accordingly, as the author indicates, the unemployment rate is on increase. This means that firms are going to cut production that would lead to decrease in output. Therefore, shortrun aggregate supply curve will shift to the left, and short run equilibrium would be to the left of LRAS curve. The aim of the monetary policy here is to shift AD curve to the right, in other words, increase aggregate demand in the economy. The easiest way to do this is to make borrowing cheaper: to decrease interest rates. The author is right: the federal fund rate is too low to be decreased. However, interest rates is not the single tool of the Fed: open market operations is also precise and effective tool in influencing the demand (in the case of stimulating, the Fed conducts open market purchases). As the demand will increase, firms will increase production, SRAS will shift back to the right to the normal, or the long run level of output In other words, changes in credit and money growth, influencing AD, have large initial effect( though with 6-8 quarter lag), but have few effect on output and unemployment in the long run. Many economists explain this effect by two reasons: firstly, system of contracts does not allow adjusting wages and prices quickly, and secondly expectations adjust slower to the long-term consequences of the monetary policy ( Labonte, 2016). Therefore, monetary policy is effective in the short-run, but neutral in the long-term period.
The same conclusion is made applying IS-Lm analysis (Figure 2). Expansionary monetary policy or increase in money supply shifts LM curve to the right. Interest rates decreases, and the borrowing becomes cheaper, as a result, increasing investments and spending. Demand is on increase, firms increase output and employment. Consequently, firms increases prices and LM curve shifts back to the initial level and the long run equilibrium remains the same. Again, monetary policy is neutral in the long-term periods.
Thus, the main aim of monetary policy is to mitigate undesirable events in the short run, in order to avoid devastating consequences, for example of price instability. Therefore, nowadays the Fed policy, developed over the long period by trial and error, is quite effective, and considering the high level of development of financial markets and independence of the US central bank, the Fed would likely mitigate negative events in economy.
Reference list:
Mishkin F.S., Matthews K., Giuliodori M. (2013) The Economics of Money, Banking & Financial Markets (European edition). Barcelona, SA: Pearson Education Limited.
Labonte M. (2016) Monetary Policy and the Federal Reserve: Current Policy and Conditions. Congressional Research Service. Retrieved from: https://www.fas.org/sgp/crs/misc/RL30354.pdf
Monetary Theory ISLM and Monetary Policy. Retrieved from: http://userwww.sfsu.edu/pgking/690pdfs/islm.pdf
