Economic Report of the President

jumps in oil and food prices as well as to shifts in money demand.The problem for the Federal Reserve is how, if at all, to adjust monetarygrowth targets in response to these changes. This requires anevaluation of the likely direct impact of monetary and credit conditionson economic activity, as well as an assessment of how alteringthe monetary targets would affect wages and prices.Response to Supply-Side ShocksWhen the economy experiences a supply shock such as the recentsurge in oil prices, the initial results are likely to be a reduction inaggregate demand and a rise in unemployment and inflation. As discussedearlier, the Federal Reserve can respond in several ways. Atone extreme, the response would aim at accommodating the shockcompletely, thus restoring real aggregate demand to its level beforethe shock and avoiding any rise in unemployment. At the other extreme,the response would attempt to offset fully both the direct andindirect inflationary effects. The intermediate position suggested earlierwould be to accommodate the direct effects of the price shockbut seek to minimize indirect effects.If the latter strategy were adopted, the monetary targets necessaryto pursue it would be identical to those prevailing before the shockonly by pure chance. Some adjustment would almost invariably be required,but whether the appropriate response entailed greater or lessmonetary growth than the original target ranges would depend onconditions prevailing in the economy at the time as well as on thecomplex dynamic responses of wages and prices after the shock.Moreover, the monetary authorities must remember that their credibilitymay be damaged if this strategy were to entail an upward adjustmentin targets. Such a consideration may lead to a less accommodativeposition than analysis based strictly on aggregate demandconditions would warrant.Changes in Money DemandShifts in money demand confront the monetary authorities with adifferent set of problems. Here the appropriate policy response isclear in theory. For example, money-demand shifts have at times inrecent years resulted in sudden reductions in the amount of moneynecessary to support a given amount of economic activity. Holding topredetermined monetary targets in the face of such shifts wouldmean a more accommodative policy than previously intended. Alternatively,by reducing monetary growth targets commensurate with thedemand shift, an unchanged degree of monetary restraint would bemaintained.Although the response is clear in theory, in practice there aremany problems. It is difficult for the Federal Reserve to know until54