Macroeconomics. Monetary policy Essay Example | Topics and Well Written Essays - 1500 words

Macroeconomics. Monetary policy - Essay Example In this formulation u* is the unique unemployment rate where inflation is stable. This Phillips curve has the property that inflation rises (the price level accelerates) when u is below u*: since actual inflation exceeds expected inflation, with adaptive expectations, inflation expectations rise over time and are factored into wage and price setting. In contrast, when unemployment exceeds the natural rate, actual inflation falls short of expected inflation, so inflation declines over time as expectations adjust downward toward reality. With chronic high unemployment, deflation is inevitable (Yellen and Akerlof 2005, p.2). According to Yellen and Akerlof, stabilization policy can significantly reduce average levels of unemployment by providing stimulus to demand in circumstances where unemployment is high but underutilisation of labour and capital does little to lower inflation. A monetary policy that vigorously fights high unemployment should, however, also be complemented by a policy that equally vigorously fights inflation when it rises above a modest target level. In their survey, Yellen and Akerlof conclude that there is a solid case for stabilization policy and that there are especially strong reasons for central banks to accord it priority in the current era of low inflation. With a nonlinear short-run Phillips curve, stabilization policy reduces average levels of joblessness and raises average output by a nontrivial amount. A nonlinear relationship between unemployment and social welfare may reflect the increasing incidence of long-duration unemployment spells as aggregate unemployment rises, the diminishing benefits associated with additional job creation as unemployment falls (2004, p.31). On Charles Bean's discussion of stabilization policy, Stanley Fischer comments the following on Bean's analysis the implications of the nonlinearity of the Phillips curve: a one percentage point reduction in an already low unemployment rate will push up inflation more than a one percentage point increase in a higher unemployment rate will reduce inflation. How should this affect policy Fischer cites that Bean's analysis shows that in the presence of a nonlinear tradeoff, the authorities should aim for a higher unemployment rate than the natural rate, because a positive shock that reduces unemployment will have a larger effect on inflation than a negative shock of the same size. Yellen and Akerlof go on that a Phillips curve that is not always accelerationist provides a further, important reason for central banks to pursue stabilization as an objective. The traditional accelerationist Phillips curve captures the following truth on inflation: when product and labour markets are tight, as typically occurs when unemployment is low, prices and wages both tend to increase. This