In this chapter, we learn: in the presence of a systematic monetary policy, we can combine the IS curve and the MP curve to get an aggregate demand (AD) curve. the Phillips curve can be reinterpreted as an aggregate supply (AS) curve. the AD and AS curves represent an intuitive version of the short-run model that describes the evolution of the economy in a single graph. modern theories that underlie monetary policy, including the debate over rules versus discretion and the importance of expectations. If we could formulate a systematic policy in response to the various kinds of shocks that can possibly hit the economy, what would the policy look like?

Monetary Policy Rules and Aggregate Demand The short-run model consists of three basic equations: The short-run model implies that high short-run output leads to an increase in inflation. By choosing the real interest rate, the central bank chooses how to make this trade-off. A monetary policy rule is a set of instructions that determines the stance of monetary policy for a given situation that might occur in the economy. If inflation is above the target, the real interest rate should be high. If inflation is below the target, the real interest rate should be low. The parameter governs how aggressively monetary policy responds to inflation.

The AD Curve We can substitute the monetary policy rule into the IS curve. The resulting equation is the aggregate demand (AD) curve, which says short-run output is a function of the rate of inflation: The AD curve describes how the central bank chooses short-run output based on the rate of inflation. If inflation is above target, then the central bank raises the interest rate to lower output below potential. We call it the AD curve is because it is built up from the demand side of the economy – consumption, investment, government purchases, and foreign demand are essential parts of the curve.

A change in inflation is a movement along the AD curve because inflation is on the vertical axis. The monetary policy rule dictates the central bank increase the interest rate if inflation is above the target. This reduces investment spending and reduces short-run output by a multiple of the reduction in investment spending. AD is flatter (output responds more strongly to deviations of inflation from the central bank’s target) when the CB is more aggressive – parameter m is greater – and when investment is more sensitive to the real interest rate – parameter b is greater. Temporary shocks to aggregate demand parameter, a, and changes in the central bank’s target inflation rate, π, shift AD.

Aggregate Supply The aggregate supply (AS) curve is the price-setting equation used by firms: The AS curve is simply the Phillips curve with a new name. Since the relationship between the current rate of inflation and short-run output is upward-sloping, it’s natural to call it an aggregate supply curve. The point in the AS graph where short-run output equals zero is equal to the inflation rate in the previous period. If the inflation rate is changing over time, the AS curve will shift over time. Inflation in the previous period, πt-1, is the expected rate of inflation in the current period, πte The curve also shifts due to the inflation shocks parameter, o.

The AS/AD Framework Combining the AS and AD curve gives us a dynamic model with two equations and two unknowns: the inflation rate, πt-1, and short-run output The Steady State In the steady state, endogenous variables R, π, and Y are constant over time and there are no shocks to the economy. In steady state, the inflation rate must be constant. Short-run output is equal to zero in the steady state…otherwise the inflation rate would change. Actual output equals potential output in the steady state. The inflation rate equals the central bank’s target in the steady state… otherwise the central bank would change R, change Y and move π toward its target.

The AD curve slopes downward because of the response of policymakers to inflation. If inflation is high, the monetary policy rule dictates increasing the interest rate. This reduces output by lowering investment demand. The AS curve slopes upward as an implication of price-setting behavior of firms embodied in the Phillips curve. When actual output is above potential, firms raise their prices by more than the usual amount to cover higher wages and other production costs.

An Inflation Shock The economy begins in steady state and is hit with a lasting increase in the price of oil. Mathematically, o, is positive for one period but this inflation shock raises the price level permanently. The AS curve shifts up as a result. Response The monetary policy rule dictates that the increase in inflation be fought by an increase in the real interest rate – reducing short-run output. Stagflation results In the next period, o returns to normal, but the AS curve does not shift back to its initial position: the rate of inflation in the previous period is now some value above the target rate of inflation: π1 > π0 = π Movement of the AS curve follows the principle of transition dynamics – movement back to the steady state is fastest when the economy is furthest from its steady state.

High inflation created by the oil shock raises expected inflation and because of sticky inflation, these expectations adjust slowly. This slows the adjustment of the AS curve back to its initial position. The slumping economy leads inflation to fall, but only slowly. Eventually the model will return to its original steady state. In summary, the impact of a price shock is that: It raises inflation directly. Even if the shock lasts for a single period, the shock raises expected inflation and inflation remains higher for a longer period of time. It takes a prolonged slump to get these expectations back to normal and the economy suffers stagflation.

Disinflation Disinflation Suppose the economy begins in steady state and policymakers decide to lower the target rate of inflation to π’. The AD curve shifts down: at any given inflation rate, the output level associated with the policy rule is reduced. π must now be lower for short-run output to equal zero as it initially does. The new rule calls for an increase in interest rates, causing a slowdown in inflation to somewhere between the old one and the new target. The economy must now move to its new steady state by the principle of transition dynamics. The change in the rate of inflation causes the AS curve to shift during the following period. Firms adjust their expectation for inflation to account for the new lower inflation rate and the AS curve shifts down As the inflation rate is still above the target, the central bank keeps actual output below potential and the inflation rate falls further. Eventually, the economy rests in its new steady state. If the classical dichotomy holds in the short run, the AD and AS curves would reach the new steady state immediately. If there is sticky inflation, a recession is needed to adjust expectations down.

A Positive AD Shock The boom is followed by recession…why bother? Suppose there is a temporary increase in the aggregate demand parameter . The AD curve will shift out such that at any given level of inflation, output increases. Increased demand will result in prices increasing. As inflation has increased, firms expect higher inflation in the future so the AS curve shifts upward over time. The inflation rate associated with zero short-run output rises. The AS curve shifts by the principle of transition dynamics until the economy has higher inflation and zero short-run output. The inflation rate now exceeds its steady state by an amount depending on the aggregate demand shock Aggregate demand shocks are temporary because the consumption, investment, government purchases, and net exports shares of potential output must sum to one. Thus, when the shock ends, the AD curve shifts back to its original position – which is like a negative shock because short-run output was already at 0. The boom is followed by recession…why bother?

Counterclockwise Loops When plotting inflation on the vertical axis and output on the horizontal axis, the economy will follow counterclockwise loops to shocks in the economy. Positive short-run output leads to rising inflation. A rise in inflation leads policymakers to reduce output.

Predicting the Fed Funds Rate The Fisher equation allows us to write the monetary policy rule in terms of the nominal interest rate: The Taylor rule suggests picking parameter values that are functions of 2. The simple monetary policy rule provides an accurate picture of the federal funds rate – except during the 1970s.

Further Thoughts on Aggregate Demand Shocks In theory, monetary policy can be used to insulate an economy from aggregate demand shocks. The monetary policy rule we specified here responds only to inflation and not output changes. CHAPTER 12 Stabilization Policy and the AS/AD Framework

Case Study: Real Business Cycle Models and the “New Economy” Variations in TFP can produce realistic fluctuations in the economy. Real business cycles are fluctuations in the economy that are driven by real forces in the economy. CHAPTER 12 Stabilization Policy and the AS/AD Framework

Greenspan attributed most gains in output to technological change. An unresolved issue is whether fluctuations in GDP are due mostly to fluctuations in potential output or due to fluctuations in actual output. Was the new economy a technological shock that changed potential output (thus not threatening to raise inflation) or an aggregate demand shock that would increase inflation? Greenspan attributed most gains in output to technological change. CHAPTER 12 Stabilization Policy and the AS/AD Framework

11.6 Empirical Evidence What are the empirical predictions of the short-run model when monetary policy is dictated by an inflation-based policy rule? CHAPTER 12 Stabilization Policy and the AS/AD Framework

Predicting the Fed Funds Rate The Fisher equation allows us to write the monetary policy rule in terms of the nominal interest rate: The Taylor rule suggests picking parameter values that are functions of 2. The simple monetary policy rule provides an accurate picture of the federal funds rate – except during the 1970s. CHAPTER 12 Stabilization Policy and the AS/AD Framework

CHAPTER 12 Stabilization Policy and the AS/AD Framework

Inflation-Output Loops When plotting inflation on the vertical axis and output on the horizontal axis, the economy will follow counterclockwise loops to shocks in the economy. Positive short-run output leads to rising inflation. A rise in inflation leads policymakers to reduce output. CHAPTER 12 Stabilization Policy and the AS/AD Framework

Empirically, when the economy booms inflation increases and the central bank slows, the economy resulting in counterclockwise loops in the data. CHAPTER 12 Stabilization Policy and the AS/AD Framework

Case Study: Forecasting and the Business Cycle To conduct economic forecasts, economists study a large number of variables of leading economic indicators – including the fed funds rate, the term structure for interest rates, claims for unemployment insurance, and the number of new houses. Professional forecasts have a difficult time predicting “turning points.” CHAPTER 12 Stabilization Policy and the AS/AD Framework

CHAPTER 12 Stabilization Policy and the AS/AD Framework

12.7 Modern Monetary Policy The Federal Reserve does not officially follow a monetary policy rule. The U.S. economy is much more complicated than the simple model. The short-run model captures many features of monetary policy as central banks are now more explicit about policies and targets. Inflation rates in industrialized countries have been well behaved for the last 25 years. CHAPTER 12 Stabilization Policy and the AS/AD Framework

CHAPTER 12 Stabilization Policy and the AS/AD Framework

More Sophisticated Monetary Policy Rules Richer monetary policy rules that account for short-run output create results that resemble the simple model we constructed. The simple policy rule we used implicitly weights short-run output. In our model, changes in short-run output lead to changes in inflation and the monetary policy rule responds to the changes in inflation – and thus implicitly, output. CHAPTER 12 Stabilization Policy and the AS/AD Framework

Rules versus Discretion Is there any benefit to creating a systematic policy? The time consistency problem suggests that even though an agent supports a particular policy, once the future comes, they have incentives to renege on their promises. CHAPTER 12 Stabilization Policy and the AS/AD Framework

After firms and workers form expectations about inflation and build them into pricing decisions, central bankers have incentives to pursue an expansionary policy. However, firms and workers anticipate the policy and build that anticipation into prices – resulting in no benefit to output. If policymakers can commit to not exploiting inflation expectations, the economy can benefit from a lower average rate of inflation. CHAPTER 12 Stabilization Policy and the AS/AD Framework

The Paradox of Policy and Rational Expectations The goal of macroeconomic policy is full employment, output at potential, and low, stable inflation. The presence of a policymaker willing to generate a large recession (raises interest rates sharply) to fight inflation makes use of the policy less likely. CHAPTER 12 Stabilization Policy and the AS/AD Framework

Our motivation for this assumption was the stickiness of inflation. Under adaptive expectations, we assume that expected inflation equals inflation in the previous period and does not change when the monetary policy rule changes: Our motivation for this assumption was the stickiness of inflation. CHAPTER 12 Stabilization Policy and the AS/AD Framework

Rational expectations says that people use all information at their disposal to make their best forecast of the rate of inflation. This information may include the costs resulting in sticky inflation, but may also add the target rate of inflation. CHAPTER 12 Stabilization Policy and the AS/AD Framework

Under rational expectations, the central bank’s willingness to fight inflation is a key determinant of expected inflation. If firms know the bank will fight aggressively to keep inflation low, they are less likely to raise prices after an inflation shock. To the extent that policymakers can influence expectations, they can reduce the costs of maintaining a low target level of inflation. CHAPTER 12 Stabilization Policy and the AS/AD Framework

Managing Expectations in the AS/AD Model We can drop the assumption of adaptive expectations and rewrite the AS curve in terms of the expected rate of inflation: CHAPTER 12 Stabilization Policy and the AS/AD Framework

If the Federal Reserve lowers the inflation target, then: The AD curve shifts down. If expectations adjust immediately and people use all information, the AS curve shifts down immediately to the new target. To the extent that the central bank can coordinate people’s expectations of inflation, it can maintain low and stable inflation without the need for recessions. CHAPTER 12 Stabilization Policy and the AS/AD Framework

CHAPTER 12 Stabilization Policy and the AS/AD Framework

Case Study: Rational Expectations and the Lucas Critique The Lucas critique says that it is inappropriate to build a macroeconomic model based on equations in which expectations are not consistent with the statistical properties of the economy. Models should incorporate the theory of rational expectations. CHAPTER 12 Stabilization Policy and the AS/AD Framework

Inflation Targeting In many countries, central banks have an explicit target rate of inflation that they seek to apply over the medium horizon. Explicit inflation targets anchor inflation expectations. This may make it easier for central banks to stimulate output. CHAPTER 12 Stabilization Policy and the AS/AD Framework

Constrained discretion is the idea that a central bank has the flexibility to respond to shocks in the short-run, but remains committed to a particular rate of inflation in the long run. CHAPTER 12 Stabilization Policy and the AS/AD Framework

Case Study: Choosing a Good Federal Reserve Chair The Romer and Romer study argues that policymakers’ views about how the economy works play a crucial role in making a good chair. Knowledge of macroeconomics is essential to successful Fed chairs. CHAPTER 12 Stabilization Policy and the AS/AD Framework

Conclusion A credible, transparent commitment to a low rate of inflation is one of the key factors in taming inflation. Such a commitment anchors inflation expectations so that shocks are deflected quickly. CHAPTER 12 Stabilization Policy and the AS/AD Framework

Commitment to low inflation makes it easier to stabilize the economy. The period after the 1980-82 recession is known as the Great Moderation because of the relative stability of the macroeconomy during this time. CHAPTER 12 Stabilization Policy and the AS/AD Framework

Summary Monetary policy often follows a systematic approach that can be characterized as a monetary policy rule. In the simple rule explored in this chapter, , the central bank increases the real interest rate whenever inflation exceeds a particular target. Although it’s difficult to imagine such a simple rule reflecting the real world, it turns out to describe monetary policy in the U.S. economy over the last few decades reasonably well. CHAPTER 12 Stabilization Policy and the AS/AD Framework

Combining a monetary policy rule with the IS curve leads to an aggregate demand (AD) curve, which describes how the central bank chooses the level of short-run output based on the current rate of inflation. The aggregate supply (AS) curve, another name for the Phillips curve, tells us that the current rate of inflation depends positively on short-run output. A booming economy leads firms to raise their prices by more than last period’s rate of inflation, leading to an even higher rate of inflation over the coming year. The equation for the AS curve is: CHAPTER 12 Stabilization Policy and the AS/AD Framework

In the basic AS/AD framework, we assume expected inflation adjusts slowly, or is sticky. In other words, we have adaptive expectations, so that . The AS/AD framework is quite intuitive. In a single graph, it allows us to study shocks to the economy as inflation shocks, aggregate demand shocks, and changes in the inflation target. The graph shows how inflation and short-run output evolve over time. In general, the principle of transition dynamics applies, and the economy moves gradually back to its steady state after a shock. These dynamics are driven by the slow adjustment of expected inflation and show up as shifts in the AS curve. CHAPTER 12 Stabilization Policy and the AS/AD Framework

Modern monetary policy recognizes that managing inflation expectations is an important key to stabilizing the economy. The theory of rational expectations says that in order to determine future inflation, people analyze all information that is available to them. Systematic monetary policy, reputation, and inflation targets are tools that central banks use to help them manage inflation expectations. By anchoring inflation expectations, central banks can achieve low inflation and stable output in the least costly fashion. CHAPTER 12 Stabilization Policy and the AS/AD Framework

CHAPTER 12 Stabilization Policy and the AS/AD Framework