Question

Student often struggle to understand why monetary policy sometimes has an effect on output and other times does not. Students tend to think either the monetary policy SHOULD or SHOULD NOT have an effect.  

Consider the following statements and relate them to the ideas of why the impact of monetary policy differs when it is anticipated vs unanticipated, and why it differs in the short run and the long run.

Bob: "Boy, I just didn't know what to expect on Dr. Smith's first exam, and I really studied wrong for it.   I'll adjust my studying techniques from now on."

Jim:   "I had Dr. Smith last semester and knew what to expect, so I was prepared."

Answer 1

Answer:

The main objective of monetary policy to bring price stability in the economy. For achieving the price stability, the central bank has various operating tools. The objective of the monetary policy can be well depicted in the following graph.

The x-axis on the graph represents the output gap and y-axis represents inflation gap. The downward concave graph is a loss function curve. The monetary policy (or central bank) need to minimize the loss function so that it reaches to zero. To achieve its target central bank either chooses to reduce the inflation gap or reduce the output gap.

In the above example, Bob was not able to anticipate Dr. Smith question paper as it was his first exam whereas Jim who had done Dr. Smith course last semester very well anticipated the question. With this anticipation of Jim and unanticipation of Bob, Jim got an advantage of being well prepared for the exam. When the same situation arises with monetary policy, with anticipation shocks (that is about which the monetary policymakers are aware of) the effect is realized on real variables. Due to positive anticipated shocks, the effect is on inflation taxes which induce an inflation premium on the nominal interest rate. Hence the shock is realized in short run and can be recovered in due course of time.

With an unanticipated shock, with expansion (positive effect) will stimuli production in the economy and with negative effect induce depression in the economy. To understand the real effect of unanticipated let's take an example:

Suppose there is unanticipated money growth in the economy. Now due to this sudden money growth in the economy, there will be a change in price (probably the prices will increase). This will induce higher production which will lead to increase in employment (by hiring more labor) and will increase the demand for intermediate products. With the increase in output, employment and income prices too will go high.