Monetary Policy Theory

Continuing from the previous post

As previewed, this post is

about “how we should respond”

Earlier we looked at how the General Equilibrium shifts due to various causes

But!

‘Ah, I get that it’s moving that way!! So are you just gonna sit there with your eyes open and watch?!

No I mean are you gonna let yourself get robbed blind with your eyes wide open!@@@ There’s gotta be some countermeasure, right!’

We’ll be looking at these countermeasures,

and what’s still a hot debate is

“Yo yo yo yo yo don’t intervene -_- if the government intervenes things get even more screwed up, it just ends up causing inflation!!!!”

“Because there’s a lag between policy and its effect!!! It doesn’t move instantaneously!!!!!”

(data lag, recognition lag, legislative lag, implementation lag, effect lag)

“So intervening just ends up disturbing something that was in equilibrium!!!”

(nonactivist)

And people on the opposite side say to this

“Haa-- so damn frustrating -- you gotta intervene appropriately for things to be even a little better,,,,, Mr. Keynes said this!!!”

“In the long-run, we all dead (in the long run, we are all dead.)”

(activist)

Now, whose side should we take????The answer?????

Since there isn’t one, that’s why it’s still a hot debate!

First, the ideal economic picture the monetary authority dreams of

is keeping the inflation rate at the target inflation those guys are aiming for (

)

Well, high is bad, yeah… obviously bad!

But if the inflation rate goes down??isn’t that a good thing???huh???

Nope!!!! The reason?????“Deflation” is scary!!

Because

let’s imagine a situation where prices are just dropping.

I could buy a car today, but wouldn’t I wait a bit and try to buy it tomorrow?

Since prices are just dropping??

No wait, I might even wait a whole year!

Words from Mr. Park Je-ga:

“Wealth is like a well — if you don’t draw from it and use it, it dries up on its own.

If frugality is excessive the people cannot enjoy themselves, and if livelihoods are destitute, only thieves multiply.”

Seems like Mr. Park Je-ga also knew the danger of not spending

If people don’t spend we’re screwed, and since deflation makes us not spend like this, it rots away like a well…. T_T

So~~~ the monetary authority sets the target inflation (

, inflation target) at around ~1%~3%, apparently!!

OK!!!So the monetary authority’s goal is to fix it at that target inflation!!

So from here on out

case by case

1. Case of a demand shock!!! How to respond

When the monetary authority does nothing at al~~l??? we covered earlier!!!

At that time ultimately output gets matched to

so output doesn’t change and the short-run equilibrium moves to where the inflation rate dropped!!!! hehe

The inflation rate dropped!!!! The monetary authority’s mood can’t be comfortable, right?!

So what scheme are these folks cooking up

(* The monetary authority can only manipulate the demand curve, they can’t touch the supply curve.. T_T)

These folks, in order to move the demand curve back to the right,

through “independent easing of monetary policy”

by lowering

will try to move the demand curve back to the right!!!

The AD’ curve will go back up to AD!!!

If it moves successfully, the inflation rate can be kept at

!!! And output also gets matched in the long run!!!!

Nothing is lost!!

Olivier Blanchard (former MIT professor, currently at the IMF) called this phenomenon

divine coincidence!!!!

2. Case where a supply shock occurs!! How to respond

-1 In the case of a permanent supply shock, what kind of response is appropriate!!

If you do nothing at this time, as we learned earlier…. ultimately the inflation rate goes up!!(output can’t be helped,,)

The black line is the situation after LRAS has moved to the left and reached equilibrium!!

So

is lower than

, that’s the state!!

The monetary authority’s goal is!!

to move it back to

, that’s the goal!! So we have to fiddle with the AD curve and move it to the left like the red one!!

Then the AS curve will follow!!! hehehe Like that

can be matched hehe

The divine coincidence phenomenon happens here too!! hehe

(Since output can’t be helped!)

-2. In the case where a temporary supply shock occurs!!! How should we respond!

If we do nothing, this too, just as we learned earlier!!!!

It goes off like this and comes back!!

Showing off my physics major a bit, you could say the AS curve bounces out as if attached to a spring and then comes back.

Due to this phenomenon, the policy options the monetary authority can take are said to be 3!

Let’s take a look

1. Just do nothing

Because, at some point it’ll come back!!

But the problem is! The spring constant might be too small, so during the time it takes to come back the economy might get totally screwed.

In this case AS’ does have a spring attached to it, but the spring constant might be too small!!

2. Shoot backward

Alright, then the monetary authority

is said to only look at

.

So the monetary authority also attaches a spring to AD’ in the exa~~ct same way and shoots!

Where?!?!?! Backward!!

Let’s see what happens if you shoot backward

At this point the monetary authority also hooks a spring onto AD and shoots backward!

And when both slowly come back

at that time

like this the monetary authority can steadily hold the inflation rate at

.

People won’t suffer from inflation, but people might suffer from the decrease in national income Y.

So we can say divine coincidence doesn’t happen.

3. Shoot forward

Just because it’s the monetary authority, do you think they only want to look at

?!?!? If the monetary authority just shoots in the opposite direction,

they can hold down national income Y….?

Wanna see?

It was here~~

Bounces out!!

At this point shoot forward!!!!

Like this!!!! hehehe

Then with this

output can be held!!

The moment you choose to maintain national income like this…..

the inflation rate becomes uncontrollable

So here too the divine coincidence phenomenon doesn’t happen.. T_T

The world is so cruel

That’s why the government and the Bank of Korea have to keep~~ fighting it out… that’s what’s normal…

Hmm… how is it in our country…??(I’m asking because I really don’t know) lollol are they doing well~hehe?

Huh but why do the government and the Bank of Korea have to fight?~??

Because the main goal of most governments is “increasing employment”!!

To increase employment they might temporarily shift AS upward to try to boost productivity,

or they might do a policy like increasing G to shift AD to the right!!

Then what inevitably follows is an increase in inflation!

So it’s right that they fight every day!!! Pbbht

Originally written in Korean on my Naver blog (2015-07). Translated to English for gdpark.blog.