CFA Level 1

By Investopedia AAA

Macroeconomics - Expectations of Monetary Policy

Expectations impact perceptions about inflation and the timing of those perceptions. The effectiveness of expansionary monetary and fiscal policy with regards to increases in output and employment is reduced by expectations. The reduction in output caused by restrictive monetary and fiscal policy will be moderated by expectations, as economic participants will more quickly anticipate the lowering of overall price levels.

Demand curves for labor and capital slope downward to the right. With other factors held constant, employers will only hire more workers if real wage rates have decreased and capital expenditures will increase only if real interest rates have declined.

Expansionary monetary and fiscal policy often assumes that workers will accept lower real wages and that investors will accept lower real rates of return. It is the willingness of workers to accept wages that are lower than what they would normally demand, and the willingness of investors to accept lower real interest rates than normal that causes employment and real production to increase. Nominal wages and interest rates remain the same; inflation is doing the job of cutting real wages and interest rates. Therefore, in order for employment and production to increase, inflation must increase so that real wages and interest rates can go down. This relationship is described by the original Phillips curve, which shows that inflation accompanies lower rates of unemployment.

As long as the public does not understand that inflation has increased, the economy can be moved according to the Phillips curve relationship.

Why would it take time for the public to recognize and adapt to the new rate of inflation?
One reason is that some workers may not be able to do anything about it. They may be locked into multi-year labor agreements that do not permit negotiation until the expiration of the labor agreement. Investors and employees might also be subject to money illusion - their attention could be focused on their nominal wages and nominal interest rates, and they may not realize that real wages and interest rates are declining. At some point in time, however, they will recognize that their real buying power (from wages and interest income) has gone down.

Also, they may not immediately see that inflation is occurring. Not all prices go up during times of inflation, so it may hard to see the big picture.

Eventually, the public will understand and adapt to the new inflationary environment and they will seek raises in wages and interest rates in order to bring them back to their old income levels. The economy will move to a long-term equilibrium position in which output and employment return to points where they were before the monetary and fiscal stimulus occurred. The major change will be that prices will be at a higher level.

This makes sense, as we should not expect major benefits to occur just from printing more paper money or running larger government deficits!

Expectations essentially reduce the time that government policymakers can fool the public into accepting cuts in real wage and real interest rates and, therefore, the positive effects of financial and monetary stimulus are moderated.

New Monetarist vs New Keynesian Feedback Rules
There are two famous new feedback rules for monetary policy. Those rules are:

  • The Taylor rule is a Keynesian feedback rule that focuses on short-term interest rates. The rule takes into account the target inflation rate, the difference between actual inflation and the target inflation rate, and the difference between real GDP and potential GDP.
  • The McCallum rule is a monetarist rule that emphasizes the growth rate of money. It states that the Federal Reserve should target a monetary base growth rate equal to the target inflation rate plus the ten-year moving average of the real GDP growth rate minus the four-year moving average of the monetary base velocity.

The major differences between the rules are:

·Targeting an interest rate versus monetary growth (as usual for Keynesians versus monetarists!).
·The Taylor rule provides for a response to fluctuations in real GDP, while the McCallum rule does not.

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