Macroeconomics For Dummies®, uk edition Published by: John Wiley & Sons, Ltd

Accounting for policy time lags

Interest rate decisions today take around 18–24 months to have their full effect on the economy. Therefore, policy makers have to be forward-looking when making monetary policy decisions today and think about what inflation is likely to be around two years in the future.

Central banks do have sophisticated models for predicting what future inflation is likely to be, but it’s a notoriously difficult task, so

policy is made under conditions of uncertainty. Achieving the target for sure is impossible, but the bank hopes that it’ll be close most of the time.

In the UK, for example, the target rate of inflation is currently 2 per cent. But achieving this target exactly and at all times is neither possible nor desirable (trying to do so would involve very large movements in the interest rate).

Instead, only if inflation is more than 1 per cent away from target (that is, outside the range 1–3 per cent) does the Bank of England have to explain in an open letter (which you can read on its website) why it failed to meet the target.

Identifying the underlying cause of the shock


The central bank has to consider the cause of inflation before deciding whether to act:


If inflation is too high compared to the target due to aggregate demand increasing too much, increasing the interest rate sounds like a good plan: it’s likely to reduce inflation and bring output back to its natural level.


If inflation is too high due to a temporary supply-side shock, such as high energy prices, the central bank will be wary of increasing interest rates, because doing so will reduce output even further. The bank may be better off waiting for output to return to its natural level.

In Figure 10-5a, the economy has experienced a positive aggregate demand shock that increased AD from AD₁ to AD₂. This event increased the price level from p₁ to p₂ and if policy makers do nothing, the price level is likely to rise further to p₃. To stop this, the central bank can increase interest rates and bring aggregate demand back down to AD₁.

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Figure 10-5: Monetary policy: (a) demand shock; (b) supply shock.


In Figure 10-5b, the economy has experienced a negative aggregate supply shock that increased the price level and simultaneously reduced output. This rather unpleasant phenomenon is sometimes called stagflation. If policy makers are worried that inflation is too high, they can increase interest rates (reducing AD), but doing so would reduce output even further. Instead, they may wait and hope that the supply shock is temporary and that the economy will return to its natural level of output.