Stabilization Policy

Fluctuations in the economy as a whole come from changes in aggregate supply or aggregate demand. Economists call exogenous changes in these curves shocksto the economy. A shock that shifts the aggregate demand curve is called a demand shock, and a shock that shifts the aggregate supply curve is called a supply shock. These shocks disrupt economic well-being by pushing output and employment away from their natural rates. One goal of the model of aggregate supply and aggregate demand is to show how shocks cause economic fluctuations.

Another goal of the model is to evaluate how macroeconomic policy can respond to these shocks. Economists use the term stabilization policyto refer to policy actions aimed at reducing the severity of short-run economic fluctuations.

Because output and employment fluctuate around their long-run natural rates, stabilization policy dampens the business cycle by keeping output and employment as close to their natural rates as possible. In the coming chapters, we examine in detail how stabilization policy works and what practical problems arise in its use. Here we begin our analysis of stabilization policy by examining how monetary policy might respond to shocks. Monetary policy is an important component of stabilization policy because, as we have seen, the money supply has a powerful impact on aggregate demand.

Shocks to Aggregate Demand

Consider an example of a demand shock: the introduction and expanded availability of credit cards. Because credit cards are often a more convenient way to make purchases than using cash, they reduce the quantity of money that people choose to hold. This reduction in money demand is equivalent to an increase in the velocity of money. When each person holds less money, the money demand parameter k falls. This means that each dollar of money moves from hand to hand more quickly, so velocity V (= 1/k) rises.

If the money supply is held constant, the increase in velocity causes nominal spending to rise and the aggregate demand curve to shift outward. In the short run, the increase in demand raises the output of the economy— it causes an economic boom. At the old prices, firms now sell more output.

Therefore, they hire more workers, ask their existing workers to work longer hours, and make greater use of their factories and equipment. price level rises, the quantity of output demanded declines, and the economy gradually approaches the natural rate of production. But during the transition to the higher price level, the economy’s output is higher than the natural rate.

What can the Fed do to dampen this boom and keep output closer to the natural rate? The Fed might reduce the money supply to offset the increase in velocity. Offsetting the change in velocity would stabilize aggregate demand. Thus, the Fed can reduce or even eliminate the impact of demand shocks on output and employment if it can skillfully control the money supply.

Date: 2015-12-11; view: 988