Chapter 23 The Challenges of Monetary Policy ©2000 South-Western College Publishing

2 What is stagflation? A condition of concurrent high unemployment and inflation

3 Exhibit Sustainable Economic Growth determined by the growth and productivity of labor and capital Long Run Short Run Full Employment Stable Prices Satisfactory External Balance compatible with full employment and stable prices Achieving these goals in the short run helps to achieve maximum sustainable economic growth in the long run

4 Price Level 1.00 Steady Noninflationary Growth Exhibit AD' $4,000$4,120$4, AD'' LRAS AD LRAS'LRAS'' Real GDP (billions) I C D BA

5 (A) = Nominal Interest Rate (B) = Expected Inflation Rate (C) = Taxes (D) = Real After Tax Return (A) – (B) – (C) = (D) (Eq. 23.1).04 – 0 – (.2 5 .04) =.03 (Eq. 23.2).06 –.02 – (2.5 .06) =.025

6 Deflation A drop in the overall price level as measured by a price index

7 Employment Act of 1946 The first act that directed policymakers to pursue policies to achieve full employment and noninflationary growth

8 Humphrey-Hawkins Full Employment & Balanced Growth Act of 1978 An act that required policymakers to pursue policies to achieve full employment and noninflationary growth

9 Natural Rate of Unemployment The rate of unemployment consistent with stable prices, believed to be about 5.5 percent

10 Price Level 1.00 An Unexpected Increase in Aggregate Demand with No Fed Response Exhibit AD' $1,500 $1, LRAS AD SRAS' Real GDP (billions) SRAS C B A

11 Price Level Possible Policymaker Response to an Unexpected Increase in Aggregate Demand Exhibit AD' LRAS AD SRAS Real GDP B A

12 Price Level Demand-Induced Recession Exhibit AD' LRAS AD SRAS Real GDP (in billions) B A SRAS' C

13 Stop-Go Policy Cycle Policy that switches from expansionary to contractionary, and so on

14 Phillips Curve A curve suggesting a trade-off between unanticipated inflation and unemployment in the short run

15 Price Level The Phillips Curve AD LRAS AD' SRAS Real GDP B A C AD''

16 Inflation The Phillips Curve Unemployment B A C

17 Supply Shock Any event that shifts the short- run aggregate supply curve

18 Cost-Push Inflation Sustained increases in the overall price level, triggered by increases in input prices

19 Accommodation When policymakers increase aggregate demand in response to an adverse supply shock

20 Price Level An Adverse Supply Shock as a Cause of Cost-Push Inflation Exhibit AD' LRAS AD SRAS Real GDP B A SRAS' C