♪ [music] ♪ [Alex] Monetary policy looks easy, when it's just a matter
of shifting some lines on a graph. But, in practice,
it's considerably more difficult. Choosing the right tools -- and when, and how to use them -- is both an art and a science. To illustrate the difficulties, let's look at a relatively
easy scenario -- a negative shock
to aggregate demand, driven by what John Maynard Keynes
called "animal spirits" -- emotions and instincts,
confidence and fear. Suppose that the economy
has been growing at a rate of 3% per year, and the inflation rate is 7%. Now imagine the consumers --
they become more pessimistic. They borrow and spend less. Banks lend less. Entrepreneurs cut back
on expansions, and they invest less. All of this causes a negative shock
to aggregate demand. The AD curve shifts to the left. Now notice that
without an intervention, real GDP growth --
it's going to decrease, and the economy
will move to point B. Now, in the long run,
when fear recedes, we'll return to our steady-state
growth level, but not without
some sluggish growth and increased unemployment, or even a recession
in the short run. Can the Fed... could it combat
this sluggish growth with monetary policy? Yes! By increasing the growth rate
of the money supply, the Fed could offset the negative
aggregate demand shock. Looks great! Disaster avoided. If only it were so easy. At least three issues
make it difficult for the Fed to choose
the right course of action at the right time. First -- the quality of the data. It takes time to gather and analyze
good data on the economy. Sometimes, in the past,
revisions to the data have occurred years after the actual events. But the Fed --
it can't wait for the revisions. It has to act now. Second -- timing. The Fed's actions take time
to affect the economy, usually some 6 to 18 months
after the fact. So even if the Fed
correctly identifies the problem and acts right away, the situation may have changed by the time that its policies
begin to take effect. And third -- control. The Fed's control
of the money supply -- it's incomplete and imperfect. Many of its tools
rely on other actors, such as banks. As we saw during
the Great Recession, the banks -- they stopped lending
like they normally do. So some of the Fed's tools
became less effective. So what happens when the Fed
doesn't get its policy just right? If the Fed undershoots, or doesn't stimulate
the economy enough to offset the aggregate demand shock, then growth -- it'll still
be sluggish in the short run, as the economy slowly adjusts
back to the natural growth rate. More problematic
is when the Fed overshoots. When the Fed increases
the money supply beyond what's needed, then the economy --
it can overheat. Sure, we may get some more
real growth in the short run, but we're also
going to get more inflation. Price signals become distorted. And it's difficult
for the Fed to course-correct. In fact, if the inflation rate
gets too high, the Fed will want to reduce
the inflation rate -- a disinflation. But that too will likely
cause unemployment. Many economists think that the Federal Reserve did
overstimulate the economy in the 1970s. By the end of the 1970s, inflation was running away
at over 13% a year. And Ronald Reagan was elected
to the presidency in 1980, in part to change economic policy. By 1983, the Federal Reserve, under cigar-chomping chairman
Paul Volcker -- it had brought inflation
down to 3%, but at the price
of a very severe recession. So the cost of stimulating
the economy in the 1970s was very likely
even more unemployment in the early 1980s. We'd sure like the Fed
to hit the "just right," the "Goldilocks" amount
of economic stimulation, but it's not easy. And remember --
this was the simple scenario, the easy scenario. Next, we're going to examine
a more difficult challenge -- the challenge the Fed faces when the economy experiences
a negative real shock, and the long-run
aggregate supply curve shifts. [Narrator] You're on your way
to mastering economics. Make sure this video sticks
by taking a few practice questions. Or, if you're ready
for more macroeconomics, click for the next video. Still here? Check out Marginal Revolution
University's other popular videos. ♪ [music] ♪
