Monetary Policy: The Negative Real Shock Dilemma

Course Outline

Monetary Policy: The Negative Real Shock Dilemma

As we’ve seen, it can be difficult for the Federal Reserve to course-correct when dealing with a sluggish economy suffering from an aggregate demand shock. Now we’re going to see what happens when a negative real shock hits.

For instance, suppose we see a reduction in the oil supply, which causes a rapid increase in the price of oil. It’s unexpected and it’s difficult for the economy to quickly adjust. A negative real shock like this will shift the long-run aggregate supply curve inward, to the left. Growth decreases and inflation increases.

How can the Fed combat this situation? Here’s where it gets really tricky: decreasing the money supply will help with inflation, but it’ll also hinder growth. Increasing the money supply will increase aggregate demand and real growth, but lead to higher inflation. Yikes!

Remember, economic data can be super difficult to get right in real-time. Higher inflation may show up well before the sluggish growth does. The Fed might take action under this incomplete data, potentially moving the economy in the wrong direction.

We’re still not done! Everything in the real world is intertwined. A negative real shock, like an oil crisis, can have an impact on consumer confidence. Can you guess what this means? Yep, a negative real shock can often be accompanied by an aggregate demand shock, making the Fed’s job all the more complicated.

We’ll cover more details on how the Fed responds to negative real shocks, and the double-whammy of a negative real shock and aggregate demand shock, in the video.

Teacher Resources


So far, we've reviewed the challenges that the Fed faces when dealing with a straightforward aggregate demand shock. Now, we're going to graduate to a more difficult scenario, more difficult for the Fed -- a negative real shock to the economy. Recall from earlier videos that a real shock, such as a rapid rise in the price of oil -- that will shift the long-run aggregate supply curve to the left, causing growth to decrease and inflation to increase.


Unfortunately, combatting these two issues -- sluggish growth and high inflation -- that requires opposite actions. To decrease inflation, the Fed would have to decrease the money supply and reduce aggregate demand. That will reduce the growth rate even further. Alternatively, the Fed can try to increase real growth by increasing the money supply and increasing aggregate demand. But that comes at the cost of even higher inflation. And remember, economic data isn't always easy to understand in real time. It sometimes happens, for example, that the higher inflation rate is seen in the data before the growth rate starts to decline.



So, the Fed -- it might start to cut back on the money supply before realizing that the economy -- it's heading towards a recession. So, the Fed may start to move the economy in the wrong direction before learning what the actual state of the economy is. And this isn't the end of the dilemma. It's common for negative real shocks and negative aggregate demand shocks to come together. In the real world, everything is intertwined. And bad news, like an oil shock, can cause people to become pessimistic and to cut back on their spending, causing aggregate demand to fall.



Now if you're confused right now, don't worry, you're not alone. Fed economists get confused as well. It's just not obvious how to correctly identify the combination of shocks that's hitting an economy. And so, there's always lots of heated debate among Fed economists and policymakers about what the right course of action is. Although the Fed has considerable power to influence aggregate demand, the complexity of the economy and the challenges of data quality, timing and control -- that leaves lots of room for error. In fact, the Federal Reserve has probably made some booms and recessions worse rather than better. Some of the errors of the Fed -- we're going to take those up in the next video. And this will help us to understand the practical challenges, which are faced by economists, acting in real time to enact monetary policy at the Federal Reserve.



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