Monetary Policy: The Best Case Scenario

Monetary policy looks easy, when it's just a matter of shifting some lines on a graph. But, in practice, it's considerably more difficult. Choosing the right tools -- and when, and how to use them -- is both an art and a science.

To illustrate the difficulties, let's look at a relatively easy scenario -- a negative shock to aggregate demand, driven by what John Maynard Keynes called "animal spirits" -- emotions and instincts, confidence and fear. Suppose that the economy has been growing at a rate of 3% per year, and the inflation rate is 7%. Now imagine the consumers -- they become more pessimistic. They borrow and spend less. Banks lend less. Entrepreneurs cut back on expansions, and they invest less. All of this causes a negative shock to aggregate demand. The AD curve shifts to the left.

Now notice that without an intervention, real GDP growth -- it's going to decrease, and the economy will move to point B. Now, in the long run, when fear recedes, we'll return to our steady-state growth level, but not without some sluggish growth and increased unemployment, or even a recession in the short run. Can the Fed... could it combat this sluggish growth with monetary policy? Yes! By increasing the growth rate of the money supply, the Fed could offset the negative aggregate demand shock. Looks great! Disaster avoided. If only it were so easy.

At least three issues make it difficult for the Fed to choose the right course of action at the right time. First -- the quality of the data. It takes time to gather and analyze good data on the economy. Sometimes, in the past, revisions to the data have occurred years after the actual events. But the Fed -- it can't wait for the revisions. It has to act now. Second -- timing. The Fed's actions take time to affect the economy, usually some 6 to 18 months after the fact. So, even if the Fed correctly identifies the problem and acts right away, the situation may have changed by the time that its policies begin to take effect.

And third -- control. The Fed's control of the money supply -- it's incomplete and imperfect. Many of its tools rely on other actors, such as banks. As we saw during the Great Recession, the banks -- they stopped lending like they normally do. So, some of the Fed's tools became less effective. So, what happens when the Fed doesn't get its policy just right? If the Fed undershoots, or doesn't stimulate the economy enough to offset the aggregate demand shock, then growth -- it'll still be sluggish in the short run, as the economy slowly adjusts back to the natural growth rate.

More problematic is when the Fed overshoots. When the Fed increases the money supply beyond what's needed, then the economy -- it can overheat. Sure, we may get some more real growth in the short run, but we're also going to get more inflation. Price signals become distorted. And it's difficult for the Fed to course-correct. In fact, if the inflation rate gets too high, the Fed will want to reduce the inflation rate -- a disinflation. But that too will likely cause unemployment. Many economists think that the Federal Reserve did overstimulate the economy in the 1970s. By the end of the 1970s, inflation was running away at over 13% a year. And Ronald Reagan was elected to the presidency in 1980, in part to change economic policy.

By 1983, the Federal Reserve, under cigar-chomping chairman Paul Volcker -- it had brought inflation down to 3%, but at the price of a very severe recession. So, the cost of stimulating the economy in the 1970s was very likely even more unemployment in the early 1980s. We'd sure like the Fed to hit the "just right," the "Goldilocks" amount of economic stimulation, but it's not easy. And remember -- this was the simple scenario, the easy scenario.

Next, we're going to examine a more difficult challenge -- the challenge the Fed faces when the economy experiences a negative real shock, and the long-run aggregate supply curve shifts.