Saturday, October 01, 2011

Monetary Policy and Price Level Stability

CFA Level 1 - Macroeconomics

Stable Prices vs. Sustainable Growth in real GDP

Price level stability refers to the concept that price levels are stable enough so that people do not feel compelled to take inflation into account when making economic decisions. Many economists believe that measured inflation in the range of 0 up to 2 or 3 percent a year is actually zero inflation. There may be quality improvements in goods that are not reflected in the official measurement of inflation; this reflects a price level measurement bias.
Price level stability is only a means to a higher goal. That goal is a rising standard of living, which depends upon sustainable growth in real GDP. Whether or not that growth is sustainable depends upon other factors such as technological advances, availability of natural resources, the willingness of people to work, the willingness of people to invest, and political stability. Monetary policy helps to create a stable environment which favors investment and saving.
Achieving Price Level Stability
The Federal Reserve can quickly affect short-term interest rates, such as three-month T-bills and rates on savings deposits. However, the impact of monetary policy on longer-term interest rates is more moderate and more difficult to predict. Longer-term interest rates are more influenced by the supply and demand for investment funds, as opposed to monetary factors. Secondly, the impact of inflation must be taken into account. For example, suppose an expansionary monetary policy is perceived to be inflationary. The impact of that policy on longer-term interest rates, such as real estate mortgages, will be to raise them.
Expansionary Monetary Policy
An expansionary monetary policy, if inflationary effects are not anticipated, should lower interest rates, particularly short-term ones. It will also have the effect of reducing velocity, as the opportunity cost of holding money is reduced. Eventually the lower interest rates will induce more personal and business spending to occur so that aggregate demand will increase. This process could take several quarters. Eventually the increased demand will cause nominal and real interest rates to go higher, which will increase the velocity of money. At that point the impact of the expansionary monetary policy will be further amplified.
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