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W E B C h a p t E r 3 The Role of Expectations in Monetary Policy 1

After World War II, economists, armed with models like the ones we developed in Chapters 20–23, felt that discretionary policies could reduce the severity of business cycle fluctuations without creating inflation. In the 1960s and 1970s,

these economists got their chance to put their policies into practice, but the results were not what they had anticipated. The economic record for that period is not a happy one: Inflation accelerated, the rate often climbing above 10%, while unemployment figures deteriorated from those of the 1950s.1

In the 1970s and 1980s, economists, including Nobel Prize winners Robert Lucas of the University of Chicago and Thomas Sargent, now at New York University, used the rational expectations theory discussed in Chapter 7 to examine why discretionary poli-cies appear to have performed so poorly. Their analysis cast doubt on whether macro-economic models can be used to evaluate the potential effects of policy and on whether policy can be effective when the public expects that it will be implemented. Because the analysis of Lucas and Sargent has such strong implications for the way policy should be conducted, it has been labeled the rational expectations revolution.2

This chapter examines the analysis behind the rational expectations revolution. We start first with the Lucas critique, which indicates that because expectations are impor-tant in economic behavior, it may be quite difficult to predict what the outcome of a discretionary policy will be. We then discuss the effect of rational expectations on the aggregate demand and supply analysis developed in Chapter 22 and explore how this theoretical breakthrough has shaped current policy-making models and debates.

LucAs critique of PoLicy evALuAtionEconomists have long used macroeconometric models to forecast economic activ-ity and to evaluate the potential effects of policy options. In essence, the models are collections of equations that describe statistical relationships among many economic variables. Economists can feed data into such models, which then churn out a forecast or prediction.

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the role of expectations in Monetary Policy

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2Other economists who have been active in promoting the rational expectations revolution are Robert Barro of Har-vard University, Bennett McCallum of Carnegie-Mellon University, Nobel Prize winner Edward Prescott of Arizona State, and Neil Wallace of Pennsylvania State University.

1Some of the deterioration can be attributed to supply shocks in 1973–1975 and 1978–1980.

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2 W E B C h a p t E r 3 The Role of Expectations in Monetary Policy

In his famous paper “Econometric Policy Evaluation: A Critique,” Robert Lucas spurred the rational expectations revolution by presenting a devastating argument against the use of macroeconometric models used at the time for evaluating policy.3

Econometric policy EvaluationTo understand Lucas’s argument, we must first understand how econometric policy evaluation is done. Say, for example, that the Federal Reserve wants to evaluate the potential effects of changes in the federal funds rate from the existing level of 5%. Using conventional methods, the Fed economists would feed different fed funds rate options—say, 4% and 6%—into a computer version of the model. The model would then predict how unemployment and inflation would change under the different scenarios. Then, the policymakers would select the policy with the most desirable outcomes.

Relying on rational expectations theory, Lucas identified faulty reasoning in this approach if the model does not incorporate rational expectations, as was true for mac-roeconometric models used by policymakers at the time: When policies change, public expectations will shift as well. For example, if the Fed raises the federal funds rate to 6%, this action might change the way the public forms expectations about where inter-est rates will be in the future. Those changing expectations, as we’ve seen, can have a real effect on economic behavior and outcomes. Yet econometric models that do not incorporate rational expectations ignore any effects of changing expectations, and thus are unreliable for evaluating policy options.

ApplicAtion ◆ The Term Structure of Interest Rates

Let’s now apply Lucas’s argument to a concrete example involving only one equation typically found in econometric models: the term structure equation. The equation relates the long-term interest rate to current and past values of the short-term interest rate. It is one of the most important equations in macroeconometric models because the long-term interest rate, not the short-term rate, is the one believed to have the larger impact on aggregate demand.

In Chapter 6, we learned that the long-term interest rate is related to an average of expected future short-term interest rates. Suppose that in the past, when the short-term rate rose, it quickly fell back down again; that is, any increase was temporary. Because rational expectations theory suggests that any rise in the short-term interest rate is expected to be only temporary, a rise should have only a minimal effect on the average of expected future short-term rates. It will cause the long-term interest rate to rise by a negligible amount. The term structure relationship estimated using past data will then show only a weak effect on the long-term interest rate of changes in the short-term rate.

Suppose the Fed wants to evaluate what will happen to the economy if it pursues a policy that is likely to raise the short-term interest rate from a current level of 3% to a permanently higher level of 5%. The term structure equation that has been estimated using past data will indicate that just a small change in the long-term interest rate will occur. However, if the public recognizes that the short-term rate is rising to a perma-nently higher level, rational expectations theory indicates that people will no longer

3Carnegie-Rochester Conference Series on Public Policy 1 (1976): 19–46.



expect a rise in the short-term rate to be temporary. Instead, when they see the interest rate rise to 5%, they will expect the average of future short-term interest rates to rise substantially, and so the long-term interest rate will rise greatly, not minimally as the estimated term structure equation suggests. You can see that evaluating the likely out-come of the change in Fed policy with an econometric model can be highly misleading.

The term structure application demonstrates another aspect of the Lucas critique. The effects of a particular policy depend critically on the public’s expectations about the policy. If the public expects the rise in the short-term interest rate to be merely tem-porary, the response of long-term interest rates, as we have seen, will be negligible. If, however, the public expects the rise to be more permanent, the response of long-term rates will be far greater. The Lucas critique points out not only that conventional econometric models cannot be used for policy evaluation, but also that the public’s expectations about a policy will influence the response to that policy.

The term structure equation discussed here is only one of many equations in econo-metric models to which the Lucas critique applies. In fact, Lucas uses the examples of consumption and investment equations in his paper. One attractive feature of the term structure example is that it deals with expectations in a financial market, a sector of the economy for which the theory and empirical evidence supporting rational expectations are much stronger. The Lucas critique should also apply, however, to sectors of the economy for which rational expectations theory is more controversial, because the basic principle of the Lucas critique is not that expectations are always rational but rather that the formation of expectations changes when the behavior of a forecasted variable changes. This less stringent principle is supported by the evidence in sectors of the economy other than financial markets. ◆

PoLicy conduct: ruLes or discretion?The Lucas critique exposed the need for new policy models that reflected the insights of rational expectations theory. Here, we explore the implications of the critique on a long-running debate among economists: whether monetary policymakers should have the flexibility to adapt their policy to a changing situation, or whether they should adopt rules, binding plans that specify how policy will respond (or not respond) to particular data such as unemployment and inflation.

Discretion and the time-Inconsistency problemPolicymakers operate with discretion when they make no commitment to future actions, but instead make what they believe in that moment to be the right policy deci-sion for the situation. Empowering policymakers to shape policy on-the-fly introduces complexities. The time-inconsistency problem we discussed in Chapter 16 reveals the potential limitations of discretionary policy. Recall that the time-inconsistency problem is the tendency to deviate from good long-run plans when making short-run decisions. Policymakers are always tempted to pursue a policy that is more expansionary than firms or people expect because such a policy would boost economic output (and lower unemployment) in the short run. The best policy, however, is not to pursue expansion-ary policy, because decisions about wages and prices reflect workers’ and firms’ expec-tations about policy (an implication of the rational expectations revolution). When



workers and firms see a central bank, for example, pursuing discretionary expansionary policy, they will recognize that this is likely to lead to higher inflation in the future. They will therefore raise their expectations about inflation, driving wages and prices up. The rise in wages and prices will lead to higher inflation, but may not result in higher output on average.

Policymakers will have better inflation performance in the long run if they do not try to surprise people with an unexpectedly expansionary policy, but instead keep inflation under control. One way to do this is to abandon discretion and adopt rules to govern policy making.

types of rulesIn contrast to discretion, rules are essentially automatic. One famous type of rule, advocated by Milton Friedman and his followers who are known as monetarists, is the constant-money-growth-rate rule, in which the money supply is kept growing at a constant rate regardless of the state of the economy. Other monetarists such as Bennett McCallum and Alan Meltzer have proposed variants of this rule that allow the rate of money supply growth to be adjusted for shifts in velocity, which has often been found to be unstable in the short run. Rules of this type are nonactivist because they do not react to economic activity. Monetarists advocate rules of this type because they believe that money is the sole source of fluctuations in aggregate demand and because they believe that long and variable lags in the effects of monetary policy will lead to greater volatility in economic activity and inflation if policy actively responds to unemployment (as discussed in Chapter 23).

Activist rules, in contrast, specify that monetary policy should react to the level of output as well as to inflation. The most famous rule of this type is the Taylor rule, which we discussed in Chapter 16. It specifies that the Fed should set its federal funds rate target by a formula that considers both the output gap (Y − YP) and the inflation gap (p - pT).

the Case for rulesAs our discussion of the time-inconsistency problem suggests, discretionary monetary policy can lead to poor economic outcomes. If monetary policymakers operate with discretion, they will be tempted to pursue overly expansionary monetary policies to boost employment in the short run but generate higher inflation (and no higher employment) in the long run. A commitment to a policy rule like the Taylor rule or the constant-money-growth-rate rule solves the time-inconsistency problem because policymakers have to follow a set plan that does not allow them to exercise discre-tion and try to exploit the short-run tradeoff between inflation and employment. By binding their hands with a policy rule, policymakers can achieve desirable long-run outcomes.

Another argument for rules is that policymakers and politicians cannot be trusted. Milton Friedman and Anna Schwartz’s monumental work, A Monetary History of the United States,4 documents numerous instances in which the Federal Reserve made serious policy errors, with the worst occurring during the Great Depression, when the Fed just stood by and let the banking system and the economy collapse (Chapter 9 and Chapter 14 discuss the Fed’s actions during the Great Depression). The politicians who make

4Milton Friedman and Anna Jacobson Schwartz, A Monetary History of the United States, 1867–1960 (Princeton, NJ: Princeton University Press, 1963).



fiscal policy are also not to be trusted because they have strong incentives to pursue policies that help them win the next election. They are therefore more likely to focus on increasing employment in the short run without worrying that their actions might lead to higher inflation further down the road. Their advocacy for expansionary policies can then lead to the so-called political business cycle, in which fiscal and monetary policy is expansionary right before elections, with higher inflation following later. (For an example, see the FYI box, “The Political Business Cycle and Richard Nixon.”)

the Case for DiscretionAlthough policy rules have important advantages, they do have serious drawbacks. First, rules can be too rigid because they cannot foresee every contingency. For example, almost no one could have predicted that problems in one small part of the financial system, subprime mortgage lending, would lead to the worst financial crisis in over 70 years, with such devastating effects on the economy. The unprecedented steps that the Federal Reserve took during this crisis to prevent it from causing a depression (described in Chapters 9 and 15) could not have been written into a policy rule ahead of time. Being able to act flexibly using discretion can thus be key to a successful mon-etary policy.

The second problem with policy rules is that they do not easily incorporate the use of judgment. Monetary policy is as much an art as a science. Monetary policymakers need to look at a wide range of information in order to decide on the best course for monetary policy, and some of this information is not easily quantifiable. Judgment is

FYI the political Business cycle and Richard nixon

You might know that Richard Nixon and his aides took some extraordinary actions to ensure a landslide vic-tory in the 1972 presidential election, such as break-ing into the offices of political rivals at the Watergate Hotel. Less well known are similar actions on the economic front ahead of the election. The Nixon administration imposed wage and price controls on the economy, which temporarily lowered the inflation rate before the election. After the election, those same moves helped lead to a surge in inflation. Nixon also pursued expansionary fiscal policy by cutting taxes. And it has been rumored that the Chairman of the Federal Reserve, Arthur Burns, succumbed to direct pressure from Nixon to maintain low interest rates through election day. The aftermath was ugly. The economy overheated and inflation rose to over 10% by the late 1970s, which was abetted by the negative supply shocks during that period (see Chapter 22).

The Nixon episode led economists and political scientists to theorize that politicians would take

steps to make themselves look good during election years. Specifically, the theory went, they would take steps to stimulate the economy before the election, leading to a boom and low unemployment that would increase their electoral chances. Unfortu-nately, the result of these actions would be higher inflation down the road, which then would require contractionary policies to get inflation under control later, with a resulting recession in the future. The resulting ups and downs of the economy would then be the result of politics and so could be characterized as a political business cycle. Although the Nixon epi-sode provided support for the existence of a political business cycle, research has not come to a definitive answer regarding whether this phenomenon is a general one.*

*The paper that launched research on the political business cycle was William Nordhaus, “The Political Business Cycle,” Review of Economic Studies 42 (1975): 169–190.



thus an essential element of good monetary policy, and it is very hard to write it into a rule. Only with discretion can monetary policy bring judgment to bear.

Third, no one really knows what the true model of the economy is, and so any policy rule that is based on a particular model will prove to be wrong if the model is not correct. Discretion avoids the straightjacket that would lock in the wrong policy if the model that was used to derive the policy rule proved to be incorrect.

Fourth, even if the model were correct, structural changes in the economy would lead to changes in the coefficients of the model. The Lucas critique, which points out that changes in policies can change the coefficients in macroeconometric models, is just one example. Another is that the relationship of monetary aggre-gates, like M1 and M2, to aggregate spending broke down in the 1980s as a result of financial innovation. Following a rule based on a constant growth rate of one of these aggregates would have produced bad outcomes. Indeed, this is what hap-pened in the case of Switzerland in the late 1980s and early 1990s, when adherence to a rule using the growth rate of monetary aggregates led to a surge in inflation (discussed in the Global box, “The Demise of Monetary Targeting in Switzerland”). Discretion enables policymakers to change policy settings when an economy under-goes structural changes.

Constrained DiscretionThe distinction between rules and discretion has strongly influenced academic debates about monetary policy for many decades. But the distinction may be too stark. As we have seen, both rules and discretion are subject to problems, and so the dichotomy between rules and discretion may be too simple to capture the realities that macroeconomic

Global the Demise of Monetary targeting in Switzerland

In 1975 the Swiss National Bank (Switzerland’s central bank) adopted monetary targeting in which it announced a growth rate target for the monetary aggregate M1. From 1980 on, the Swiss switched their growth rate target to an even narrower monetary aggregate, the monetary base. Although monetary targeting was quite successful in Switzerland for many years, it ran into serious problems with the introduction of a new interbank payment system, the Swiss Interbank Clearing (SIC), and a wide-ranging revision of commercial banks’ liquidity requirements in 1988. These structural changes caused a severe drop in banks’ desired holdings of deposits at the Swiss National Bank, which were the major compo-

nent of the monetary base. A smaller amount of the monetary base was now needed relative to aggregate spending, altering the relationship between the two, and so the 2% target growth rate for the monetary base was far too expansionary. Inflation subsequently rose to over 5%, well above that of other European countries.

High inflation rates horrified the Swiss, who have always prided themselves on maintaining a low-inflation environment even when the rest of Europe did not. These problems with monetary targeting led the Swiss to abandon it in the 1990s and adopt a much more flexible framework for the conduct of monetary policy.*

*For a further discussion of monetary targeting in Switzerland, see Chapter 4 of Ben S. Bernanke, Thomas Laubach, Frederic S. Mishkin, and Adam S. Posen, Inflation Targeting: Lessons from the International Experience (Princeton, NJ: Princeton University Press, 1999).



policymakers face. Discretion can be a matter of degree. Discretion can be a relatively undisciplined approach that leads to policies that change with the personal views of policymakers or with the direction of political winds. Or it might operate within a more clearly articulated framework, in which the general objectives and tactics of the policymakers—although not their specific actions—are committed to in advance. Ben Bernanke, now chairman of the Federal Reserve, along with the author of this textbook, came up with a name for this type of framework, constrained discretion.5 Constrained discretion imposes a conceptual structure and inherent discipline on poli-cymakers, but without eliminating all flexibility. It combines some of the advantages ascribed to rules with those ascribed to discretion.

the roLe of credibiLity And A noMinAL AnchorAn important way to constrain discretion is, as was earlier discussed in Chapter 16, by committing to a nominal anchor, a nominal variable—such as the inflation rate, the money supply, or an exchange rate— that ties down the price level or inflation to achieve price stability. For example, as discussed in Chapter 16, if a central bank has an explicit target for the inflation rate, say, 2%, and takes steps to achieve this target, then the inflation target becomes a nominal anchor. Alternatively, a government could commit to a fixed exchange rate between its currency and a sound currency like the dollar and use this as its nominal anchor. If the commitment to a nominal anchor has credibility—that is, it is believed by the public—it has important benefits.

Benefits of a Credible Nominal anchorFirst, a credible nominal anchor has elements of a behavior rule. Just as rules help to prevent the time-inconsistency problem in parenting by helping adults to resist pursu-ing the discretionary policy of giving in, a nominal anchor can help overcome the time-inconsistency problem by providing an expected constraint on discretionary policy. For example, if monetary policymakers commit to a nominal anchor of achieving a specific inflation objective, say, a 2% inflation rate, then they know that they will be subject to public scrutiny and criticism if they miss this objective or pursue policies that are clearly inconsistent with this objective, such as an interest rate target that is too low. To avoid embarrassment and possible punishment, they will be less tempted to pursue overly expansionary, discretionary policies in the short run that will be inconsistent with their commitment to the nominal anchor.

Second, a credible commitment to a nominal anchor will help to anchor inflation expectations, which leads to smaller fluctuations in inflation. It thus contributes to price stability, but also helps stabilize aggregate output. Credibility of a commitment to a nominal anchor is therefore a critical element in enabling monetary policy to achieve both of its objectives, price stability and stabilizing economic activity. In other words, credibility of a nominal anchor helps make monetary policy more efficient.

We will use the aggregate demand and supply framework to show analytically why a credible nominal anchor helps produce this desirable outcome. First we will look at

5See Ben S. Bernanke and Frederic S. Mishkin, “Inflation Targeting: A New Framework for Monetary Policy?” Journal of Economic Perspectives 11 (Spring 1997): 97–116.



the effectiveness of stabilization policy when it is responding to an aggregate demand shock, and then we will do the same when it is responding to an aggregate supply shock. We will also look at the benefits of credibility for anti-inflation policy.

Credibility and aggregate Demand ShocksWe now examine the importance of credibility in the short run when positive and nega-tive demand shocks are present.

positive Aggregate Demand Shock Let’s first look at what happens in the short run when a positive aggregate demand shock occurs. For example, suppose businesses suddenly get new information that makes them more optimistic about the future, and so they increase their investment spending. As a result of this positive demand shock, in panel (a) of Figure 1 the aggregate demand curve shifts to the right from AD1 to AD2, moving the economy from point 1 to point 2. Aggregate output rises to Y2 and inflation rises above the inflation target of pT to p2. As we saw in Chapter 23, the appropriate response to stabilize inflation and economic activity is to tighten monetary policy and shift the short-run aggregate demand curve back down to AD1 in order to move the economy back to point 1. However, because of the long lags until monetary policy has an effect on aggregate demand, it will take some time before the short-run aggregate demand curve shifts back to AD1.

Now let’s look at what happens to the short-run aggregate supply curve. Recall from Chapter 22 that the short-run aggregate supply curve is as follows:

p = pe + g(Y - YP) + r

Inflation = Expected Inflation + g * Output Gap + Price Shock

If the commitment to the nominal anchor is credible, then the public’s expected inflation pe will remain unchanged and the short-run aggregate supply curve will remain at AS1. Inflation will therefore not go higher than p2, and over time as the short-run aggregate demand curve shifts back down to AD1 inflation will fall back down to the inflation target of pT.

But what if monetary policy is not credible? The public would worry that the mon-etary authorities are willing to accept a higher inflation rate than pT and are not willing to drive the short-run aggregate demand curve back to AD1 quickly. In this case, the weak credibility of the monetary authorities will cause expected inflation pe to rise and so the short-run aggregate supply curve will rise, shifting from AS1 to AS3 and sending the economy to point 3 in the short run, where inflation has risen further to p3. Even if the monetary authorities tighten monetary policy and return the aggregate demand curve to AD1, the damage is done: Inflation has risen more than it would have if the central bank had credibility. Our aggregate demand and supply analysis thus yields the following conclusion: Monetary policy credibility has the benefit of stabilizing infla-tion in the short run when faced with positive demand shocks.

negative Demand Shock Panel (b) of Figure 1 illustrates a negative demand shock. For example, suppose consumer confidence dips and consumer spending de-clines. The aggregate demand curve shifts left from AD1 to AD2, and the economy moves to point 2 in the short run where aggregate output has fallen to Y2, which is below po-tential output YP, and inflation has fallen to π2, below the target level of πT. To stabilize



output and inflation, the central bank eases monetary policy to move the aggregate demand curve back to AD1. If the central bank has high credibility, expected inflation will remain unchanged, the short-run aggregate supply curve will remain at AS1, and the economy will return to point 1.

FIGurE 1 Credibility and aggregate Demand ShocksIn panel (a), the positive aggregate demand shock shifts the aggre-gate demand curve to the right from AD1 to AD2, mov-ing the economy from point 1 to point 2. If mon-etary policy is not credible, expected inflation will rise and so the short-run aggregate sup-ply curve will rise and shift to the left to AS3, sending the economy to point 3, where inflation has risen further to π3. In panel (b) the negative aggregate demand shock shifts the aggregate demand curve left from AD1 to AD2, and the economy moves to point 2. If monetary policy is not credible, inflation expecta-tions might rise and the short-run aggregate supply curve will rise and shift to the left to AS3, sending the economy to point 3, where aggregate output has fallen even further to Y3.

Step 1. Positive aggregatedemand shock shifts theAD curve rightward . . .

Aggregate Output, Y

Y3

InflationRate, �

Y2

�3�2

AS1

(a) Positive Aggregate Demand Shocks

YP

LRAS

AD1

AD2

AS3

3

2

1�T

Step 2. moving the economy to point 2.

Step 3. With no credibility,the AS curve shifts upward . . .

Step 4. moving theeconomy to point 3 andin�ation rises even higher.

Step 1. Negative aggregatedemand shock shifts theAD curve to the left . . .

Aggregate Output, Y

Y3

InflationRate, �

Y2

�3�2

AS1

(b) Negative Aggregate Demand Shocks

YP

LRAS

AD1

AS3

3

2

1�T

AD2

Step 2. moving theeconomy to point 2.

Step 3. With no credibility,the AS curve shifts upward . . .

Step 4. moving theeconomy to point 3,where output fallseven further.



However, what if the central bank’s credibility is weak? When the public sees an easing of monetary policy, it might become concerned that the central bank is losing its commitment to the nominal anchor and will pursue inflationary policy in the future. In this situation, inflation expectations might increase, and so the short-run aggregate sup-ply curve will rise to AS3, sending the economy to point 3, where aggregate output has fallen even further to Y3. Weak credibility causes a negative demand shock to produce an even greater contraction in economic activity in the short run. We have the following additional result: Monetary policy credibility has the benefit of stabilizing economic activity in the short run when faced with negative demand shocks.

Credibility and aggregate Supply ShocksNow let’s look at what happens in Figure 2 if a negative aggregate supply shock occurs. If energy prices increase, the short-run aggregate supply curve shifts up and to the left. How much the aggregate supply curve will shift, however, depends on the amount of credibility the monetary authorities have. If the credibility of the nominal anchor is strong, inflation expectations will not rise, so the upward and leftward shift of the short-run aggregate supply curve to AS2 will be small. When

FIGurE 2 Credibility and aggregate Supply Shocks If the credibility of monetary policy is high, the negative aggregate supply shock shifts the short-run aggre-

gate supply curve only to AS2 and the economy moves to point 2, where the rise in inflation to π2 will then be minor, while the fall in output to Y2 will also be minor. If credibility is weak, then inflation expectations will rise substantially and the upward shift of the short-run aggregate supply curve will be much larger, moving it up and to the left to AS3. The economy will move to point 3, with worse outcomes on both inflation and output, that is, with inflation higher at p3 and output lower at Y3.

Step 1. With high credibility,the short-run aggregatesupply curve shifts to AS2 . . .

Aggregate Output, YY3

InflationRate, �

Y2

AS1

YP

LRAS

AD1

AS2

AS3

3

1�1

�2

�3

Step 3. With low credibility, theshort-run aggregate supply curveshifts even further to AS3 . . .

2

Step 2. and the economy movesto point 2, with a smaller declinein output and a rise in in�ation.

Step 4. and economymoves to point 3, with alarger decline in outputand a larger rise in in�ation.



the economy moves to point 2 in the short run, the rise in inflation to π2 will then be minor, while the fall in output to Y2 will also be minor. If, on the other hand, the central bank’s commitment to the nominal anchor is perceived as weak, then inflation expectations will rise substantially and the upward shift to the left of the short-run aggregate supply curve will be much larger, moving it up to AS3. Now the economy will move to point 3 in the short run, with worse outcomes on both inflation and output, that is, with inflation higher at p 3 and output lower at Y3. We reach the following conclusion: Monetary policy credibility has the benefit of producing better outcomes on both inflation and output in the short run when faced with negative supply shocks.

The benefits of credibility when the economy is hit by negative supply shocks are exactly what we see in the data, as the following application illustrates.

ApplicAtion ◆ A Tale of Three Oil Price Shocks

In 1973, 1979, and 2007, the U.S. economy was hit by three major negative supply shocks when the price of oil rose sharply; yet in the first two episodes, inflation rose sharply, whereas in the most recent episode it rose much less, as we can see in panel (a) of Figure 3. In the case of the first two episodes, monetary policy credibility was extremely weak because the Fed had been unable to keep inflation under control, which had resulted in high inflation. In contrast, when the third oil price shock hit in 2007–2008, inflation had been low and stable for quite a period of time, so the Fed had more credibility that it would keep inflation under control. One reason that has been offered to explain why the last oil price shock appears to have had a smaller effect on inflation in the recent episode is that monetary policy has been more credible. Our aggregate demand and supply analysis provides the reasoning behind this view.

In the first two episodes, in which the commitment to a nominal anchor and cred-ibility were weak, the oil price shocks would have produced a surge in inflation expec-tations and a large upward and leftward shift in the short-run aggregate supply curve to AS3 in Figure 2. Thus, the aggregate demand and supply analysis predicts there would be a sharp contraction in economic activity and a sharp rise in inflation. This is exactly what we see in panels (a) and (b) of Figure 3. The economic contractions were very severe, with unemployment rising to above 8% in the aftermath of the 1973 and 1979 oil price shocks. In addition, inflation shot up to around double-digit levels.

In the 2007–2008 episode, the outcome was quite different. Through greater policy credibility established over many years, inflation expectations remained grounded when the oil price shock occurred. As a result, the short-run aggregate supply curve shifted up and to the left much less, to only AS2 in Figure 2. The aggregate demand and supply analysis predicts that a much smaller increase in inflation would result from the negative supply shock, while the contraction in economic activity would also be less. Indeed, this is what transpired up until the global financial crisis entered its virulent phase in the fall of 2008. Inflation rose by much less than in the previous episodes, while the economy held up fairly well until the financial crisis took a disastrous turn in October 2008 (see Chapter 9). Only then did the economy go into a tailspin, but it is clear that this was not the result of the negative supply shock. Inflation actually fell quite dramatically, indicating that a massive negative demand shock was the source of the sharp contraction in economic activity. ◆



Credibility and anti-Inflation policySo far we have examined the benefits of credibility when the economy is buffeted by demand and supply shocks. By the end of the 1970s, the high inflation rate (then over 10%) helped shift the primary concern of policymakers to the reduction of inflation. What role does credibility play in the effectiveness of anti-inflation poli-cies? The aggregate demand and supply diagram in Figure 4 will help us answer this question.

FIGurE 3 Inflation and unemployment 1970–2010In the 1973 and 1979 oil shock epi-sodes, inflation was initially high and the Fed’s commit-ment to a nominal anchor was weak, whereas in the 2007 episode, inflation was initially low and the Fed’s cred-ibility was high. The result was that inflation and unem-ployment rose more in the first two episodes than in the last episode, with unemployment rising sharply in the third episode only after the 2007–2009 crisis took a disastrous turn in October 2008.

6

019801970 1975 1985 19951990 2000 2005

14

12

8

4

2

16

Infla

tion

Rat

e (%

ann

ual r

ate)

10

2010

Panel (a) Inflation

Year

6

019801970 1975 1985 19951990 2000 2005

8

4

2

12

Une

mp

loym

ent

Rat

e (%

)

10

2010

Year

Panel (b) Unemployment

1973 oilshock

1979 oilshock 2007 oil

shock

1973 oilshock

1979 oilshock

2007 oilshock



Aggregate Output, Y

InflationRate, �

AD1

AS4

AD4

AS3

1

4

�1 = 10%

�3

�4 = 2%

�2

YPY2 Y3

LRASAS1

32

Step 1. Autonomousmonetary tighteningshifts the AD curveto the left . . .

Step 2. moving theeconomy to point 2 ifthe central bank doesnot have credibility,where both outputand in�ation falls.

Step 3. moving theeconomy to point 3if the central bankhas credibility, whereoutput falls by lessand in�ation by more.

Step 4. Eventually economy movesto point 4 where in�ation falls to 2%.

FIGurE 4 Credibility and anti-inflation policyAnti-inflation policy shifts the aggregate demand curve to the left from AD1 to AD2. If the central bank lacks credibility, the short-run aggregate supply curve remains at AS1 and the economy moves to point 2, where output falls to Y2 and inflation falls to p2. If the central bank has credibility, then expected inflation declines and the short-run aggregate supply curve shifts down to AS3. The economy moves to point 3, where output has fallen by less, to Y3, and inflation has fallen by more, to p3. Eventually the economy moves to point 4, but with credibility, the anti-inflation policy is more effective, lowering inflation faster and at less cost in terms of output.

Suppose that the economy has settled into a sustained 10% inflation rate at point 1, with the aggregate demand curve at AD1 and the short-run aggregate supply curve at AS1. Now suppose that a new Federal Reserve chairman is appointed who decides that inflation must be stopped. He convinces the FOMC to tighten monetary policy so that the aggregate demand curve is shifted to the left to AD4, which in the long run will move the economy to point 4 and slow inflation down to the 2% inflation objective.

If the central bank has very little credibility, then the public will not be convinced that the central bank will stay the course to reduce inflation and they will not revise their inflation expectations down from the 10% level. The result is that the short-run aggregate supply curve will remain at AS1 and the economy will move to point 2. Although inflation will fall to p2, output will decline to Y2.

However, what if, instead, the central bank has high credibility and so the public believes that the central bank will do whatever it takes to lower inflation. In this case, expectations of inflation will fall and the short-run aggregate supply curve will fall to AS3 and the economy will move to point 3. Inflation will then fall even further to p3, and output will decline by less, to Y3. Indeed, in the extreme case, in which the central bank is perfectly credible, there is even a possibility that inflation expectations will immediately decline to the 2% level and then the short-run aggregate supply curve would shift all the way down to AS4. In this case, the economy would immediately move to point 4, where inflation has declined to the 2% inflation objective, and yet output would remain at YP. In this case, the anti-inflation policy would be costless because it would not require any loss of output. Although this last scenario is unlikely,



Global Ending the Bolivian Hyperinflation: A Successful Anti-inflation program

The most remarkable anti-inflation program in recent times was implemented in Bolivia. In the first half of 1985, Bolivia’s inflation rate was run-ning at 20,000% and rising. Indeed, the inflation rate was so high that the price of a movie ticket often rose while people waited in line to buy it. In August 1985, Bolivia’s new president announced his anti-inflation program, the New Economic Policy. To rein in money growth and establish credibility, the new government took drastic actions to slash the budget deficit by shutting down many state-owned enterprises, eliminating subsidies, freezing public sector salaries, and collecting a new wealth tax. The finance ministry was put on a new foot-ing; the budget was balanced on a day-by-day basis.

Without exceptions, the finance minister would not authorize spending in excess of the amount of tax revenue that had been collected the day before. The Bolivian inflation was stopped in its tracks within one month, and the output loss was minor (less than 5% of GDP).

Certain hyperinflations before World War II were also ended with small losses of output, using policies similar to Bolivia’s,* and a more recent anti-inflation program in Israel that also involved substantial reductions in budget deficits sharply reduced infla-tion without any clear loss of output. Without doubt, credible anti-inflation policies can be highly success-ful in eliminating inflation.

*For an excellent discussion of the end of four hyperinflations in the 1920s, see Thomas Sargent, “The Ends of Four Big Inflations,” in Inflation: Causes and Con-sequences, ed. Robert E. Hall (Chicago: University of Chicago Press, 1982), pp. 41–98.

we have shown the following result: The greater is the credibility of the central bank as an inflation fighter, the more rapid will be the decline in inflation and the lower will be the loss of output to achieve the inflation objective.

Evidence that credibility plays an important role in successful anti-inflation poli-cies is provided by the dramatic end of the Bolivian hyperinflation in 1985 (see the Global box). But establishing credibility is easier said than done. You might think that an announcement by policymakers at the Federal Reserve that they plan to pursue an anti-inflation policy might do the trick. The public would expect this policy and would act accordingly. However, that conclusion implies that the public will believe the policymakers’ announcement. Unfortunately, that is not how the real world works.

The history of Federal Reserve policy making suggests that the Fed has not always done what it set out to do. In fact, during the 1970s, the chairman of the Federal Reserve Board, Arthur Burns, repeatedly announced that the Fed would pursue a vigorous anti-inflation policy, yet instead of raising real interest rates when inflation rose, he actually lowered them. Such episodes reduced the credibility of the Federal Reserve in the eyes of the public and, as Figure 4 predicts, the resulting lack of credibility had serious consequences. The reduction of inflation that occurred from 1981 to 1984 was bought at a very high cost; the 1981–1982 recession that helped bring the inflation rate down was one of the most severe recessions in the post–World War II period.

The U.S. government can play an important role in establishing the credibility of anti-inflation policy. We have seen that large budget deficits may help stimulate infla-tionary monetary policy, and when the government and the Fed announce that they will pursue a restrictive anti-inflation policy, it is less likely that they will be believed unless the federal government demonstrates fiscal responsibility. Another way to say this



is to use the old adage, “Actions speak louder than words.” When the government takes actions that will help the Fed adhere to anti-inflation policy, the policy will be more credible. Unfortunately, this lesson has sometimes been ignored by politicians in the United States and in other countries.

ApplicAtion ◆ Credibility and the Reagan Budget Deficits

The Reagan administration was strongly criticized for creating huge budget deficits by cut-ting taxes in the early 1980s. In the aggregate supply and demand framework, we usually think of tax cuts as stimulating aggregate demand and increasing aggregate output. Could the expectation of large budget deficits have helped create a more severe recession in 1981–1982 after the Federal Reserve implemented an anti-inflation monetary policy?

Some economists answer yes, using a diagram like Figure 4. They claim that the prospect of large budget deficits made it harder for the public to believe that an anti-inflationary policy would actually be pursued when the Fed announced its intention to do so. Consequently, the short-run aggregate supply curve remained at AS1 instead of falling to AS3, with the result that the economy moved to point 2 rather than point 3 in Figure 4. As our analysis in Figure 4 shows, the result of the Fed’s anti-inflation policy was a slowing in the inflation rate to below 5% by the end of 1982, but this was very costly: Unemployment reached a peak of 10.7%.

If the Reagan administration had actively tried to reduce deficits instead of raising them by cutting taxes, what might have been the outcome of the anti-inflation policy? Instead of moving to point 2, the economy might have moved to point 3, leading to an even more rapid reduction in inflation and a smaller loss of output.

Reagan is not the only head of state who ran large budget deficits while espousing an anti-inflation policy. Britain’s Prime Minister Margaret Thatcher preceded Reagan in this activity, and economists such as Thomas Sargent assert that the reward for her policy was a climb of unemployment in Britain to unprecedented levels.

Although many economists agree that the Fed’s anti-inflation program lacked credibility, especially in its initial phases, not all of them agree that the Reagan budget deficits were the cause of that lack of credibility. The conclusion that the Reagan budget deficits helped create a more severe recession in 1981–1982 is controversial. ◆

APProAches to estAbLishing centrAL bAnk credibiLityOur analysis has demonstrated that a credible nominal anchor that anchors inflation expectations is a key element to the success of monetary policy. But how do you achieve this credibility? We have already discussed several approaches in earlier chapters. One approach, discussed in Chapter 16, is through continued success at keeping inflation under control through concerted policy actions. The preceding application and the previ-ous discussion in Chapter 16 show that this approach proved successful for the Federal Reserve during the Greenspan and Bernanke years. An approach that has been growing in popularity in recent years is inflation targeting, also discussed in Chapter 16, which involves public announcement of a medium-term numerical target for inflation and a commitment to achieve it. Another nominal anchor that some countries have successfully used to keep inflation under control is for a country to peg its exchange rate to an anchor



country that already has a strong nominal anchor. We discussed this strategy, sometimes called exchange-rate targeting, in Chapter 18. Another approach to increasing central bank credibility is to give it more independence from the political process, discussed in Chapter 13. One additional approach, not discussed in earlier chapters but discussed below, is to appoint “conservative” central bankers.

appoint “Conservative” Central BankersKenneth Rogoff of Harvard University suggested that another way to establish central bank credibility is for the government to appoint central bankers who have a strong aversion to inflation.6 He characterized these central bankers as “conservative,” although a better description would be “tough” or “hawkish on inflation.” (See the Inside the Fed box, “The Appointment of Paul Volcker, Anti-Inflation Hawk,” for an example of the appointment of a “conservative” central banker.)

6Kenneth Rogoff, “The Optimal Degree of Commitment to an Intermediary Monetary Target,” Quarterly Journal of Economics (November 1985): 169–189.

Inside the Fed the Appointment of paul Volcker, Anti-inflation Hawk

President Jimmy Carter appointed Paul Volcker to be the chairman of the Federal Reserve in August 1979. Prior to that, inflation had been climb-ing steadily, and by that month, the annual CPI inflation rate had reached 11.8%. Volcker was the quintessential “conservative” central banker because he was a well-known inflation hawk who had made it clear to the president that he would take on inflation and wring it out of the system. Shortly after Volcker ‘s taking the helm of the Fed, in October 1979 the FOMC started raising inter-est rates dramatically, increasing the federal funds rate by over eight percentage points to nearly 20% by April 1980. However, with a sharp economic contraction starting in January 1980, Volcker blinked and took his foot off the brake, allowing the federal funds rate to decline to around the 10% level by July, when the economy started to recover. Unfortunately, this monetary medicine had not done the trick, and inflation remained very high, with CPI inflation still remaining above 13%. Volcker then showed his anti-inflation, hawkish mettle: The Fed raised the federal funds rate to the 20% level by January 1981 and kept it there until July. Then in the face of the most severe

recession in the post–World War II period up to then, which started in July 1981, the Fed kept the federal funds rate at a level around 15% until July 1982, despite a rise in the unemployment rate to nearly 10%. Finally, only with the inflation rate starting to fall in July did the Fed begin to lower the federal funds rate.

Volcker’s anti-inflation credentials had now been fully established, and by 1983 inflation had fallen below 4% and remained around that level for the rest of Volcker’s tenure at the Fed through 1987. Volcker had reestablished the credibility of the Fed as an inflation fighter with the result that inflation expectations had now stabilized, ending the period of high inflation in the United States that had become known as the “Great Inflation.” Volcker became a monetary policy hero and has been lauded ever since as one of the greatest cen-tral bankers of all time. Indeed, even after he left the Fed he continued to play a prominent role in policy discussions, for example, serving on the Eco-nomic Advisory Board under President Obama and authoring the so-called “Volcker rule,” discussed in Chapter 11, that restricted banks trading with their own money (proprietary trading).



Key terms

When the public sees an appointment of a “conservative” central banker, it will expect that he or she will be less tempted to pursue expansionary monetary policy to exploit the short-run tradeoff between inflation and unemployment and will do whatever it takes to keep inflation under control. As a result, inflation expectations and realized inflation are likely to be more stable, with the benefits outlined previ-ously.

The problem with this approach to solving credibility problems is that it is not clear that it will continue to work over time. If a central banker has more “conservative” preferences than the public, why won’t the public demand that central bankers who are more in tune with their preferences be appointed? After all, in a democratic society, government officials are supposed to represent the will of the people.

Summary

constant-money-growth-rate rule, p. 4

constrained discretion, p. 7

credibility, p. 7

discretion, p. 3

macroeconometric models, p. 1

monetarists, p. 4

political business cycle, p. 5

rules, p. 3

1. The simple principle (derived from rational expec-tations theory) that how expectations are formed changes when the behavior of forecasted vari-ables changes led to the famous Lucas critique of econometric policy evaluation. Lucas argued that when policy changes, how expectations are formed changes; hence the relationships in an econometric model will change. An econometric model that has been estimated on the basis of past data will no lon-ger be the correct model for evaluating the effects of this policy change and may prove to be highly mis-leading. The Lucas critique also points out that the effects of a particular policy depend critically on the public’s expectations about the policy.

2. Advocates of rules to conduct monetary policy believe that rules solve the time-inconsistency problem because policymakers have to follow a set plan that enables them to stick to the plan and achieve desirable long-run outcomes. Advocates of discretion believe that rules are way too rigid because they cannot foresee every contingency and do not allow the use of judg-ment. Constrained discretion imposes a conceptual

structure and its inherent discipline on policymakers, but it does so without eliminating all flexibility, so that it combines some of the advantages ascribed to rules with those ascribed to discretion.

3. An important way to constrain discretion is by com-mitting to a credible, nominal anchor, a nominal vari-able, such as the inflation rate, the money supply, or an exchange rate, that ties down the price level or inflation to achieve price stability. A credible nominal anchor helps solve the time-inconsistency problem and anchor inflation expectations. Credibility has the benefit of stabilizing both output and inflation fluctuations and also enables anti-inflation policies to lower inflation at a lower cost in terms of lost output.

4. Approaches to establishing credibility include imple-menting actual policies to keep inflation low, inflation targeting, exchange-rate targeting, and the promotion of central bank independence. Another approach to establishing central bank credibility is the appointment of a “conservative” central banker (like Paul Volcker) who is hawkish on controlling inflation.



QuestionsAll questions are available in MyEconLab atwww.myeconlab.com.

1. What does the Lucas critique say about the limitations of our current understanding of the way the economy works?

2. “The Lucas critique by itself casts doubt on the ability of discretionary stabilization policy to be beneficial.” Is this statement true, false, or uncertain? Explain your answer.

3. Suppose an econometric model based on past data predicts a small decrease in domestic investment when the Federal Reserve increases the federal funds rate. Assume that the Federal Reserve is considering an increase in the federal funds rate target to fight inflation and promote a low inflation environment that promotes investment and economic growth.

a. Discuss the implications of the econometric model’s predictions if individuals interpret the increase in the federal funds rate target as a sign that the Fed will keep inflation at low levels in the long run.

b. What would be Lucas’s critique of this model?

4. If the public expects the Fed to pursue a policy that is likely to raise short-term interest rates permanently to 12%, but the Fed does not go through with this policy change, what will happen to long-term interest rates? Explain your answer.

5. In what sense can greater central bank independence make the time-inconsistency problem worse?

6. What are the arguments for and against policy rules?

7. If, in a surprise victory, a new administration is elected to office that the public believes will pursue inflation-ary policy, predict what might happen to the level of output and inflation even before the new administra-tion comes into power.

8. Many economists are worried that a high level of bud-get deficits may lead to inflationary monetary policies in the future. Could these budget deficits have an effect on the current rate of inflation?

9. In some countries, the president chooses the head of the central bank. The same president can fire the head of the central bank and replace him or her with another director at any time. Explain the implications of such a situation for the conduct of monetary policy. Do you think the central bank will follow a monetary policy rule, or engage in discretionary policy?

10. What are the benefits and costs of sticking to a set of rules in each of the following cases? How do each of these situations relate to the conduct of economic policy?

a. Going on a diet.

b. Raising children.

11. How does the case of Switzerland’s monetary targeting strategy demonstrate the case against monetary policy rules?

12. How is constrained discretion different from discretion in monetary policy? How are the outcomes likely to be different?

13. In general, how does credibility (or lack thereof) affect the aggregate supply curve?

14. As part of its response to the global financial crisis, the Fed lowered the federal funds rate target to nearly zero by December 2008 and nearly tripled the monetary base between 2008 and 2011, a considerable easing of monetary policy. However, survey-based measures of five- to ten-year inflation expectations remained low through most of this period. Comment on the Fed’s credibility to fight inflation.

15. “The more credible the policymakers who pursue an anti-inflation policy, the more successful that policy will be.” Is this statement true, false, or uncertain? Explain your answer.

16. Why did the oil price shocks of the 1970s affect the economy differently than the oil price shocks in 2007?

17. Central banks that engage in inflation targeting usu-ally announce the inflation target and time period for which that target will be relevant. In addition, central bank officials are held accountable for their actions (e.g., they could be fired if the target is not reached), which is also public information. Explain why trans-parency is such a fundamental ingredient of inflation targeting.

18. Suppose the statistical office of a country does a poor job in measuring inflation and reports an annualized inflation rate of 4% for a few months, while the true inflation rate has been around 2.5%. What would happen to the central bank’s credibility if it is engaged in inflation targeting and its target was 2%, plus or minus 0.5%?

19. What are the purposes of inflation targeting and how does this monetary policy strategy achieve them?



20. How can establishing an exchange-rate target bring credibility to a country with a poor record of inflation stabilization?

21. What does it mean to be a “conservative” central banker?

All applied problems are available in MyEconLab at www.myeconlab.com.

22. Suppose the central bank is following a constant money growth rule, and the economy is hit with a severe economic downturn. Use an aggregate supply and demand graph to show what the possible effects would be. How does this situation reflect on the cred-ibility of the central bank if it maintains the money growth rule? How does this reflect on its credibility if it abandons the money growth rule to respond to the downturn?

23. Suppose country A has a central bank with full credibil-ity, and country B has a central bank with no credibility. How does the credibility of each country affect the speed of adjustment of the aggregate supply curve to policy announcements? How does this affect output stability? Use an aggregate supply and demand diagram to dem-onstrate.

24. Suppose two countries have identical aggregate demand curves and potential levels of output, and g is

the same. Assume that in 2013, both countries are hit with the same negative supply shock. Given the table of values below for inflation in each country, what can you say, if anything, about the credibility of each coun-try’s central bank? Explain your answer.

applied problems

country A country B

2012 3.0% 3.0%

2013 3.8% 5.5%

2014 3.5% 5.0%

2015 3.2% 4.3%

2016 3.0% 3.8%

Web Exercises 1. Robert Lucas won the Nobel Prize in economics. Go

to nobelprize.org/nobel_prizes/economics/ and locate the press release on Robert Lucas. What was his Nobel Prize awarded for? When was it awarded?

Web referenceshttp://www.newschool.edu/nssr/het/

A brief biography of Robert Lucas, including a list of his publications.

25. How does a credible nominal anchor help improve the economic outcomes that result from a positive aggre-gate demand shock? How does it help if a negative aggregate supply shock occurs? Use graphs of aggregate supply and demand to demonstrate.


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