[Joseph_E._Stiglitz,_Carl_E._Walsh]_Economics(Bookos.org) (1)

Do Central Banks Respond Only to Inflation? We have assumed that
the central bank adjusts policy when inflation changes. This convenient simplification
captures an important aspect of how many major central banks conduct policy
today. It helps explain why the Fed did not initially raise interest rates as the unemployment
rate fell to very low levels in the late 1990s—as long as inflation seemed
stable, the Fed did not alter its policy.
But few central banks (if any!) react only to inflation. The goals of monetary
policy are low, stable inflation and overall economic stability and growth.
If the economy enters a recession, central banks normally lower interest rates to
help stimulate aggregate expenditures and moderate the rise in unemployment.
That the Fed cannot simply look at inflation is illustrated by two recent cases
in point.
Thinking Like an Economist
REAL VALUES MATTER FOR INCENTIVES
Economists believe that to understand how individuals and
firms behave, we should assume they make rational decisions.
In making decisions, individuals and firms respond to incentives.
But to affect decisions, a change in incentives has to be
a real change—it has to reflect an actual alteration in the
trade-offs the decision maker faces. A worker will thus be
concerned with how much her wages can purchase—the real
value of wages, not simply their amount in terms of dollars.
If a worker’s nominal wage rises by 10 percent but prices also
rise by 10 percent, her incentive to supply labor is unaffected.
Supplying an extra hour of labor increases her nominal income
by more than before, but it yields the same real income as it
did before prices and wages rose. The incentive to work is
unchanged.
Similarly, households and firms will base decisions about
borrowing and investing on the real costs of borrowing and
the real returns to investing, and the riskiness associated
with each. In deciding whether to borrow to finance a car,
an individual must weigh the consumption of other goods
and services that must be given up in order to make that purchase.
If the interest rate on the car loan is 12 percent, but
he expects prices and his nominal income to be rising at
3 percent each year because of inflation, then the dollars he
uses each year to pay the interest on the loan will be worth
3 percent less than the year before. The effective real interest
rate on the loan is 9 percent. Now suppose that when he
took out the car loan, inflation had been zero rather than 3 percent
per year. His incentive to borrow would be unaffected
if the interest rate on the loan fell to 9 percent: though he
would pay fewer dollars each year, those dollars would be
worth more since there is no inflation. The real cost is the
same; so if nothing else has changed, the incentives to borrow
are also unchanged.
The riskiness of an investment also depends on inflation.
Suppose you invest in a bond that will pay you 8 percent
interest for the next six years. It may seem to be
riskless—after all, you know you will receive 8 percent on
your investment. But if inflation turns out to average 2 percent,
your real return will only be 6 percent; and if inflation
averages 8 percent, your real return will be zero! Because
there is always some uncertainty about future inflation, real
returns will be uncertain even when the nominal rate of return
is fixed.
Economic decisions are based on the real interest rate,
not the nominal interest rate. Changes in the real interest rate
alter individuals’ incentives to act.
742 ∂ CHAPTER 33 THE ROLE OF MACROECONOMIC POLICY