♪ [music] ♪ [Alex] So far, we've reviewed
the challenges that the Fed faces when dealing with a straightforward
aggregate demand shock. Now, we're going to graduate
to a more difficult scenario, more difficult for the Fed -- a negative real shock
to the economy. Recall from earlier videos
that a real shock, such as a rapid rise
in the price of oil -- that will shift the long-run
aggregate supply curve to the left, causing growth to decrease and inflation to increase. Unfortunately, combatting
these two issues -- sluggish growth
and high inflation -- that requires opposite actions. To decrease inflation,
the Fed would have to decrease the money supply
and reduce aggregate demand. That will reduce
the growth rate even further. Alternatively, the Fed can try
to increase real growth by increasing the money supply and increasing aggregate demand. But that comes at the cost
of even higher inflation. And remember, economic data
isn't always easy to understand in real time. It sometimes happens, for example,
that the higher inflation rate is seen in the data before the growth rate
starts to decline. So the Fed -- it might start
to cut back on the money supply before realizing
that the economy -- it's heading towards a recession. So the Fed may start to move
the economy in the wrong direction before learning
what the actual state of the economy is. And this isn't the end
of the dilemma. It's common
for negative real shocks and negative aggregate
demand shocks to come together. In the real world,
everything is intertwined. And bad news, like an oil shock,
can cause people to become pessimistic
and to cut back on their spending, causing aggregate demand to fall. Now if you're confused right now,
don't worry, you're not alone. Fed economists
get confused as well. It's just not obvious
how to correctly identify the combination of shocks
that's hitting an economy. And so there's always
lots of heated debate among Fed economists
and policymakers about what
the right course of action is. Although the Fed has
considerable power to influence aggregate demand, the complexity of the economy
and the challenges of data quality, timing and control --
that leaves lots of room for error. In fact, the Federal Reserve
has probably made some booms and recessions worse
rather than better. Some of the errors of the Fed -- we're going to take those up
in the next video. And this will help us to understand
the practical challenges, which are faced by economists, acting in real time
to enact monetary policy at the Federal Reserve. [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] ♪
