Interest rate (r ) Inflation rate (π) Fed Reaction Rule If the Fed sees the inflation rate rising… …it moves to raise interest rates r0r0 r1r1 π1π1 π0π0.

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Presentation transcript:

Interest rate (r ) Inflation rate (π) Fed Reaction Rule If the Fed sees the inflation rate rising… …it moves to raise interest rates r0r0 r1r1 π1π1 π0π0 B A

45 Income Aggregate Demand and Output AD 1 (with new, higher interest rate, r 1 ) E1E1 E0E0 AD 0 (with old interest rate, r 0 ) Y1Y1 Y0Y0 A B

Fed sees inflation rising Raises interest rates Investment is discouraged Aggregate demand falls Equilibrium GDP falls

Output (Y ) Inflation rate (π )Aggregate Demand Equilibrium (ADE) If inflation rises… …the Fed takes action to “cool off” the economy Y1Y1 π1π1 π0π0 Y0Y0 A B

Fed sees inflation falling Lowers interest rates Investment is encouraged Aggregate demand rises Equilibrium GDP rises

Output (Y ) Inflation rate (π ) ADE 0 ADE 1

Output (Y ) Inflation rate (π ) ADE 1 ADE 0 5% target 10% target

Output (Y ) Inflation rate (π ) Aggregate Supply Response (ASR) Maximum Capacity Y* Recession Wage- Price Spiral

Output (Y ) Inflation rate (π ) ASR 0 ASR 1

Output (Y ) Inflation rate (π ) ASR 1 ASR 0 Expansion of Maximum Capacity

Output (Y ) Inflation rate (π ) ASR Y* Recession ADE E0E0

Unemployment Rate (percent) Inflation (percent per year)

Output (Y ) Inflation rate (π ) ASR Y* ADE 1 ADE 0 E1E1 E0E0 Recession

Unemployment Rate (percent) Inflation (percent per year)

Output (Y ) Inflation rate (π ) ASR Y* ADE 1 ADE 0 E1E1 E0E0 Wage- Price Spiral

Unemployment Rate (percent) Inflation (percent per year)

Output (Y ) Inflation rate (π ) ASR 0 Y* ADE 0 ADE 1 E0E0 E1E1 ASR 1

Unemployment Rate (percent) Inflation (percent per year)

Output (Y ) Inflation rate (π ) ASR 0 ASR 1 ADE E1E1 E0E0 Lower Capacity

Output (Y ) Inflation rate (π ) ASR 0 ASR 1 ADE E1E1 E0E0

Unemployment Rate (percent) Inflation (percent per year)

Output (Y ) Inflation rate (π ) ASR Y* Recession ADE 0 ADE 1 E0E0 E1E1

Output (Y ) Inflation rate (π ) ASR 0 Y* Recession ADE 0 E0E0 E1E1 ASR 1 ADE 1

Unemployment Rate (Percent) Inflation (Percent Per Year)

Unemployment Rate (percent) Inflation (percent per year)

Output (Y ) Inflation rate (π ) ASR 1 ASR 0 ASR 2 ADE E0E0 E2E2 E1E1 Higher Capacity

Output (Y ) Inflation rate (π ) Classical ASR Y* ADE

Year Peak Trough GDP Y* AA B

Output (Y ) Inflation rate (π ) ASR Y* ADE A B

Output (Y ) Inflation rate (π ) Y* ADE 1 ADE 0 E1E1 E0E0 Classical ASR ASR 1 ASR 0