Keeping inflation in check Melissa’s complaint…why? In the long-run, output equals potential output irrespective of the rate of inflation. Since inflation is a nuisance, you may as well keep it in check. The Story When inflation exceeds the Central Bank’s (CB’s) target, the CB raises the nominal interest rate it controls. With inflation and inflationary expectations “sticky”, a higher nominal interest rate raises the real interest rate above the “natural rate” of interest (the MPK). The high real interest rate reduces spending, particularly investment spending, via the IS relation. Reduced spending slows economic activity and, via Okun’s Law, increases unemployment…the economy goes into recession. With the economy in recession, inflation slows via the Phillips Curve (PC) relation, just like the CB intended. With output down, unemployment high, and inflation slowed, wages and prices do not rise as rapidly as they otherwise would. The Phillips Curve shifts down. If inflation is still above its target rate, the CB maintains a real interest rate above the natural rate of interest…but not as high as before. Output remains below potential and inflation slows yet more.

Alternative Rules 12.8 Taylor Rule: concern for output and unemployment as well as inflation.  Less aggressive response to inflation since tight money reduces output and exacerbates unemployment Price shock  more inflation but less output reduction Negative demand shock  less of a recession 12.9 Offset demand shocks entirely Just focus on output deviations from potential output Demand shock: As economy expands, CB raises real interest rate crowding out investment spending, resulting in less of an expansion than otherwise

12.3 A negative price shock (oil prices fall) In immediate response to reduced inflation, the CB lowers interest rates. The economy expands so inflation doesn’t fall by as much as it otherwise would. Nonetheless, the economy settles at a lower inflation rate than the CB’s target. In the next period, there is no further price shock. Since inflation is lower than usual (and expected to remain so), wage demands are moderated—the Phillips Curve shifts down from it’s pre-shock level. The reduced inflationary pressure allows the CB to keep interest rates low (the real rate below its “natural rate”) but not as low as when the negative price shock hit. – The economy settles above full employment but somewhat closer to full employment than it was before as inflation rises toward the CB’s target. Since output exceeded potential output during this period, inflation is higher than people expected it to be…but still below target. – People adjust their inflationary expectations upward causing a further upward shift in the Phillips Curve. In response, the CB raises interest rates. Output declines (along the AD curve), approaching full employment equilibrium. Since output exceeded potential during this period, inflation increases, approaching the CB’s target at full employment equilibrium.

Problem 12.4 Decline in export demand…a negative demand shock Output declines below potential (AD shifts left by a multiple of the decline in export demand). Inflation declines along the Phillips Curve, allowing the CB to reduce interest rates. The contraction of output is less than it would be in the absence of the CB’s response. The economy settles below potential output with inflation below the CB’s target. Since inflation is lower than usual (and expected to remain so), wage demands are moderated—the Phillips Curve shifts down from it’s pre-shock level. The reduced inflationary pressure allows the CB to keep interest rates low (the real rate below its “natural rate”), making for an expansion of output back toward full employment. Since output remains below potential during this period, inflation declines yet more. The PC continues to shift downward, output continues to approach potential, and inflation continues to fall until full employment output is achieved. We imagine the demand shock is reversed at this point (a on average equals zero). The economy retraces its path back to full employment at target π.