Monetary Policy: The Negative Real Shock Dilemma

Negative Real Shock to the Economy

In this video, we learn about the challenges that the Fed faces when dealing with a negative real shock to the economy. We also learn how negative real shocks and negative aggregate demand shocks can come together.

The Dilemma of Combating Sluggish Growth and High Inflation

• A real shock, such as a rapid rise in the price of oil, will shift the long-run aggregate supply curve to the left, causing growth to decrease and inflation to increase.

• 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, increasing real growth by increasing the money supply and increasing aggregate demand comes at the cost of even higher inflation.

Challenges Faced by Economists in Identifying Shocks Hitting an Economy

• Economic data isn't always easy to understand in real-time.

• Sometimes higher inflation rate is seen in data before growth rate starts declining.

• Negative real shocks and negative aggregate demand shocks can come together making it difficult for economists to identify which combination of shocks is hitting an economy.

Practical Challenges Faced by Economists Enacting Monetary Policy at Federal Reserve

• The complexity of the economy and challenges of data quality, timing, and control leave lots of room for error.

• The Federal Reserve has probably made some booms and recessions worse rather than better.

Conclusion

This section provides a conclusion on what was covered in this video.

• The next video will take up some of the errors of the Fed and help us understand the practical challenges faced by economists enacting monetary policy at Federal Reserve.