Chap_17_-_Monetary_Policy[1] - Monetary Policy Most central...

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© K. A. Kramer, 2009 Monetary Policy Most central banks are charged with maintaining price stability, which is another way of saying that they are supposed to keep inflation in check. The Fed has a more complicated mission. It is charged with promoting, “the goals of maximum employment, stable prices, and moderate long term-interest rates.” Maximum employment means trying to maintain full employment so that real GDP will be as close to potential GDP as possible. It also means trying keep the economy growing at the maximum sustainable rate possible. Stable prices means keeping the inflation rate low. And moderate long term interest rates means keeping the nominal interest rate near the real interest rate. When the inflation rate is low, the nominal interest rate is near the real interest rate, so often people just talk about the Fed trying to maintain price stability and full employment. Often, the Fed emphasizes price stability over full employment. The justification for this is that economies with low inflation provide the best environments for households and firms to make the savings and investment decisions that bring economic growth. So having low inflation encourages growth in real GDP. In the long term, price stability and low unemployment are goals that are in harmony. But in the short term, especially with the tools that they Fed can use, decreasing inflation can increase unemployment, and decreasing unemployment can increase inflation. So sometimes the fed has to prioritize low unemployment over price stability, or price stability over low unemployment. How does the Fed measure inflation? The Fed measures inflation using something called the Personal Consumption Expenditure (PCE) deflator. If you remember, GDP = C + I + G + NX. So we can calculate nominal C using current year prices, and real C using base year prices. The PCE is the ratio or nominal C to real C: PCE = C no min al C real × 100 So if in 2006 nominal consumption was $8 trillion, and real consumption was $6 trillion using 2005 as a base year, then the PCE would be: PCE = $8 trillion $6 trillion × 100 = 133 Because this allows quantities to fluctuate, the PCE avoids some of the substitution bias of the CPI.
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© K. A. Kramer, 2009 2 The price of food and fuel tend to fluctuate a lot, so the fed then excludes them from the PCE, and uses this to calculate the core inflation rate , which is the annual percentage change in the PCE excluding the prices of food and fuel. The core inflation rate is less volatile than changes in the PCE, and the Fed believes that it provides a better indication of whether price stability is being achieved. So you can see that in general the PCE inflation rate and the core inflation rate move together, but the core inflation rate swings around less. This is important because the Fed doesn’t want to respond to something that is just a temporary fluctuation. It needs to have a sense of long term trends. Price stability
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This note was uploaded on 09/08/2011 for the course ECON 100 taught by Professor Pgking during the Spring '08 term at S.F. State.

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Chap_17_-_Monetary_Policy[1] - Monetary Policy Most central...

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