1. Money and Monetary Policy

2. The Real Economy WHERE WE ARE AND WHERE WE’RE HEADING
Real factors that are independent of the price level determine potential GDP and the natural unemployment rate.
Investment demand and saving supply determine the amount of investment, the real interest rate and, along with population growth, human capital growth, and technological change, determine the growth rate of real GDP per capita.

3. The Money Economy WHERE WE ARE AND WHERE WE’RE HEADING
Money—the means of payment—consists of currency and bank deposits.
Banks create money and the Fed influences the quantity of money through its open market operations, which determines the monetary base and the federal funds rate.
Next, we explore the effects of money on the economy.

4. 11
The Monetary System
CHAPTER CHECKLIST
When you have completed your study of this chapter, you will be able to
1 Define money and describe its functions.
2 Describe the functions of the Federal Reserve System (the Fed).
3 Explain how the Fed and commercial banks crate the money supply in the economy.
Notes and teaching tips: 10 and 13.
To view a full-screen figure during a class, click the red “expand” button.
To return to the previous slide, click the red “shrink” button.
To advance to the next slide, click anywhere on the full screen figure.
To enhance your lecture, check out the Lecture Launchers, Land Mines, and Class Activities in the Instructor’s Manual.

5. Definition of Money 11.1 WHAT IS MONEY?
Money is any commodity or token that is generally accepted as a means of payment.
A Commodity or Token
Money is something that can be recognized.
Money can be divided up into small parts.

6. The Functions of Money 11.1 WHAT IS MONEY? Generally Accepted
Money can be used to buy anything and everything.
Means of Payment
A means of payment is a method of settling a debt.
The Functions of Money
Money performs three vital functions:
Medium of exchange
Unit of account
Store of value

7. 11.1 WHAT IS MONEY?
Medium of Exchange
Medium of exchange is a object that is generally accepted in return for goods and services.
Without money, you would have to exchange goods and services directly for other goods and services—an exchange called barter.

8. 11.1 WHAT IS MONEY? Unit of Account
A unit of account is an agreed-upon measure for stating the prices of goods and services.
Table 11.1 shows how a unit of account simplifies price comparisons.

9. 11.1 WHAT IS MONEY? Store of Value
A store of value is any commodity or token that can be held and exchanged later for goods and services.
The more stable the value of a commodity or token, the better it can act as a store of value and the more useful it is as money.
Money doesn’t pay interest, so it is inferior to other assets as a store of value.

10. Money Today 11.1 WHAT IS MONEY?
Money in the world today is called fiat money.
Fiat money is objects that are money because the law decrees or orders them to be money.
The objects that we use as money today are
Currency
Deposits at banks and other financial institutions
Our money today is fiat money. To reinforce this point, as a simple experiment, take a dollar bill out of your pocket in class and pretend to buy a pencil from the first student in class. Tell that student that she can now use that dollar to buy anything from the next student in her row. Ask each student to “go along” with the experiment by pretending that what is being bought each time is only worth a dollar. The dollar will continue to circulate around the room until everyone has had a chance to “buy something” with it. Now, pass around a piece of paper with George W. Bush’s name (or, perhaps your name!) on it and the phrase “One Dollar” printed somewhere on it. Ask your students how far this note is likely to get around the class. Most students will say that it won’t get as far as even the first transaction because this new note is not a socially accepted medium of exchange. However, now ask what might happen if I (the instructor) agreed to convert these George W. Bush notes into genuine U.S. one‐dollar notes upon demand. Students will now be indifferent between accepting these new notes versus receiving the “real thing,” Federal Reserve notes. What happens is that the George W. Bush notes, which previously were only pieces of paper, have now effectively become money. That is, they are now considered money (in our fictional but otherwise possibly real example). In fact, as long as people believe they will be converted into actual dollar bills there might never be any reason for people to demand original greenbacks. You can tell your students that this is no different than the story of the goldsmiths in olden days who originally acted as simply caretakers or depositories of people’s gold. As soon as the script or gold certificates that circulated began to be accepted as means of payment there was no further need of demanding payment in gold because most people regarded the gold certificates as being “as good as gold.”

11. 11.1 WHAT IS MONEY? THIS NOTE IS LEGAL TENDER
FOR ALL DEBTS, PUBLIC AND PRIVATE
Our money today is fiat money. To reinforce this point, as a simple experiment, take a dollar bill out of your pocket in class and pretend to buy a pencil from the first student in class. Tell that student that she can now use that dollar to buy anything from the next student in her row. Ask each student to “go along” with the experiment by pretending that what is being bought each time is only worth a dollar. The dollar will continue to circulate around the room until everyone has had a chance to “buy something” with it. Now, pass around a piece of paper with George W. Bush’s name (or, perhaps your name!) on it and the phrase “One Dollar” printed somewhere on it. Ask your students how far this note is likely to get around the class. Most students will say that it won’t get as far as even the first transaction because this new note is not a socially accepted medium of exchange. However, now ask what might happen if I (the instructor) agreed to convert these George W. Bush notes into genuine U.S. one‐dollar notes upon demand. Students will now be indifferent between accepting these new notes versus receiving the “real thing,” Federal Reserve notes. What happens is that the George W. Bush notes, which previously were only pieces of paper, have now effectively become money. That is, they are now considered money (in our fictional but otherwise possibly real example). In fact, as long as people believe they will be converted into actual dollar bills there might never be any reason for people to demand original greenbacks. You can tell your students that this is no different than the story of the goldsmiths in olden days who originally acted as simply caretakers or depositories of people’s gold. As soon as the script or gold certificates that circulated began to be accepted as means of payment there was no further need of demanding payment in gold because most people regarded the gold certificates as being “as good as gold.”

12. Official Measures of Money: M1 and M2
11.1 WHAT IS MONEY?
Official Measures of Money: M1 and M2
M1 consists of currency in circulation (coins and bills), traveler’s checks, and checkable deposits owned by individuals and businesses.
M2 consists of M1 plus savings deposits and small time deposits, money market funds, and other deposits (i.e. M2 = M1 + a few less liquid accounts).

13. Official Measures of Money: M1 and M2
11.1 WHAT IS MONEY?
Official Measures of Money: M1 and M2
Most economic analysis of monetary policy focuses on M1, which is referred to as Money Supply.
The money supply is created by the Federal Reserve System (FED) and commercial banks.

14. 11.3 THE FEDERAL RESERVE SYSTEM
The Federal Reserve System (the Fed) is the central bank of the United States.
The FED Today video
What are the 3 responsibilities of the FED?
Count how many times the words “confidence”, “stability”, “trust”, are mentioned in the video.

15. 11.4 REGULATING THE QUANTITY OF MONEY
Money Supply Model
The money supply is created by the Federal Reserve System (FED) and commercial banks.

16. 11.4 REGULATING THE QUANTITY OF MONEY
𝑅 – reserves
𝐶𝑈 – currency in circulation
𝑀𝐵 – monetary base
𝑀𝐵=𝑅+𝐶𝑈
𝐷 – checkable deposits
𝑀 – the quantity of money (M1)
𝑀=𝐷+𝐶𝑈 𝑅 𝐶𝑈 𝐷 𝑀 𝑀𝐵

17. 11.4 REGULATING THE QUANTITY OF MONEY
𝑟𝑑 – reserve/deposit ratio
𝑟𝑑= 𝑅 𝐷
𝑐𝑑 – currency/deposit ratio (currency drain)
𝑐𝑑= 𝐶𝑈 𝐷
In this case, the quantity of money is proportional to monetary base:
𝑀 𝑀𝐵 = 𝐷+𝐶𝑈 𝑅+𝐶𝑈 = 𝐷/𝐷+𝐶𝑈/𝐷 𝑅/𝐷+𝐶𝑈/𝐷 𝑀 𝑀𝐵 = 1+𝑐𝑑 𝑟𝑑+𝑐𝑑 =𝑚𝑚

18. 11.4 REGULATING THE QUANTITY OF MONEY
The Money Multiplier
The money multiplier (𝑚𝑚) is the change in the money supply resulting from a $1 increase in the monetary base:
Δ𝑀=𝑚𝑚∙Δ𝑀𝐵 𝑚𝑚= 1+𝑐𝑑 𝑟𝑑+𝑐𝑑

19. 11.4 REGULATING THE QUANTITY OF MONEY
Example of money supply creation
Suppose that the public wants to hold currency/deposit ratio of 𝑐𝑑=0.6, and the required reserve/deposit ratio is 𝑟𝑑=0.2. The initial consolidated balance sheet of commercial banks is:
Find the monetary base, the money supply and the money multiplier in this economy.
Suppose that the central bank conducts an open market purchase of securities from the commercial banks, at the amount of $10. Find the new monetary base, the money supply, the currency in circulation, and present the new consolidated balance sheet of commercial banks.
Assets
Liabilities
𝑅 = 20
𝑆𝑒𝑐 = 15
𝐿 = 75
𝐷 = 100
𝐸 = 10
110

20. 12
Money and Inflation
CHAPTER CHECKLIST
When you have completed your study of this chapter, you will be able to
1 Explain how in the long run, the quantity of money determines the price level and money growth brings inflation.
2 Identify the costs of inflation and the benefits of a stable value of money.
Notes and teaching tips: 7, 8, 14, 16, 23, 29, 41, and 49.
To view a full-screen figure during a class, click the red “expand” button.
To return to the previous slide, click the red “shrink” button.
To advance to the next slide, click anywhere on the full screen figure.
To enhance your lecture, check out the Lecture Launchers, Land Mines, and Class Activities in the Instructor’s Manual.

21. What causes inflation?

22. What causes inflation?
The highest inflation rates recorded in history (hyperinflations)

23. What causes inflation?
Intuitively, inflation (increasing prices) means that the value of money decreases. This happens mostly due to rapid increase in money supply.
“Inflation is always and everywhere a monetary phenomenon in the sense that it is and can be produced only by a more rapid increase in the quantity of money than in output. ... A steady rate of monetary growth at a moderate level can provide a framework under which a country can have little inflation and much growth. It will not produce perfect stability; it will not produce heaven on earth; but it can make an important contribution to a stable economic society.” Milton Friedman.

24. 12.2 MONEY, THE PRICE LEVEL, AND INFLATION
Money Impact in the Short-Run
Most economists recognize that, under certain conditions, monetary policy can have real effects on the economy in the short run.
Faster money growth can sometimes boost an economy under recession.
More importantly, money contraction is often blamed for recessions.
The Fed can influence short term interest rates in the short run. But in the long run, the Fed must come into line with more fundamental market forces. In the market loanable funds, long-term interest rates balance supply and demand at a nominal interest rate that incorporates the expected long-term inflation rate. Other (short term) interest rates align with the long term rate because long term and short term bonds are close substitutes. Given the equilibrium interest rate, if the quantity of money exceeds the quantity that people want to hold, they spend the excess and the price level rises.

25. 12.2 MONEY, THE PRICE LEVEL, AND INFLATION
Money and Inflation in the Long Run
All economists agree that the long-run impact of faster money growth is higher inflation.
A key empirical observation about the quantity of money and the price level is that:
In the long run, a given percentage change in the quantity of money brings an equal percentage change in the price level.
The Fed can influence short term interest rates in the short run. But in the long run, the Fed must come into line with more fundamental market forces. In the market loanable funds, long-term interest rates balance supply and demand at a nominal interest rate that incorporates the expected long-term inflation rate. Other (short term) interest rates align with the long term rate because long term and short term bonds are close substitutes. Given the equilibrium interest rate, if the quantity of money exceeds the quantity that people want to hold, they spend the excess and the price level rises.

26. 12.2 MONEY, THE PRICE LEVEL, AND INFLATION
The Quantity Theory of Money
Quantity theory of money is the oldest theory of inflation. It links the growth rate of money supply and inflation.

27. 12.2 MONEY, THE PRICE LEVEL, AND INFLATION
The Quantity Theory of Money Equation:
𝑀𝑉=𝑃𝑌
𝑀 – money supply (M1)
𝑃 – Price level (GDP deflator)
𝑌 – Real GDP
𝑉 – velocity of circulation (𝑉=𝑃∙𝑌/𝑀), i.e. the average number of times each dollar is used in a year.

28. 12.2 MONEY, THE PRICE LEVEL, AND INFLATION
The Quantity Theory of Money Equation:
𝑀𝑉=𝑃𝑌
Or in approximate growth rates:
𝑀 + 𝑉 = 𝑃 + 𝑌
Example: Suppose real GDP grows at 2%, and velocity is constant. What would be the long run inflation if the money supply grows at (𝑎) 5%? (𝑏) 10%?
𝑎 𝜋= 𝑀 − 𝑌 =5%−2%=3% (𝑏) 𝜋= 𝑀 − 𝑌 =10%−2%=8%

29. 12.2 MONEY, THE PRICE LEVEL, AND INFLATION
Example: Since the recession of 2008, the money supply in the U.S. has more than doubled. Nevertheless, inflation rate was low: 1% - 2%. The growth rate of real GDP was also slow (~1%). Using the quantity theory of money, explain how is that possible.
Solution:
𝑀(×2)𝑉(?)=𝑃𝑌
Since the right hand did not change much, the velocity must have decreased dramatically. See the next graph.

30. 12.2 MONEY, THE PRICE LEVEL, AND INFLATION

31. 12.2 MONEY, THE PRICE LEVEL, AND INFLATION
Hyperinflation
If the quantity of money grows rapidly, the inflation rate will be very high.
An inflation rate that exceeds 50 percent a month is called hyperinflation.
50 percent a month is 12,875 percent per year.
The highest inflation rate in recent times was in Zimbabwe, where inflation peaked at 231,150, percent a year in July 2008.

32. 12.3 THE COST OF INFLATION Inflation is costly for four reasons:
Tax costs
Shoe-leather costs
Confusion costs
Uncertainty costs

33. Tax Costs 12.3 THE COST OF INFLATION
Government gets revenue from inflation.
Inflation Is a Tax
You have $100 and you could buy 5 t-shirts at $20 each.
If price of t-shirts goes up to $25, the same $100 can buy only 4 t-shirts.
Note: an increase in price of t-shirts is equivalent to 20% tax on money holdings, so with original price you can buy 4 t-shirts.

34. 12.3 THE COST OF INFLATION Inflation, Saving, and Investment
The income tax on nominal interest income drives a wedge between the before-tax real interest rate paid by borrowers and the after-tax real interest rate received by lenders.
Before tax real interest (borrowers): 𝑟≈𝑖−𝜋
After tax real interest rate (lenders): 𝑟 𝐿 ≈𝑖 1−𝑡 −𝜋
𝑟 𝐿 ≈ 𝑟+𝜋 1−𝑡 −𝜋=𝑟− 𝑟+𝜋 𝑡 Wedge b/w real interest rates: 𝑟 𝐿 −𝑟=− 𝑟+𝜋 𝑡
Lenders receive smaller real interest rate due to taxes and due to higher inflation.

35. 12.3 THE COST OF INFLATION Inflation, Saving, and Investment Example
Suppose that real interest rate is 𝑟=3% and tax rate is 𝑡=25%. Find the after-tax real interest rate for lenders, if they pay taxes on the nominal interest rate.
The wedge ( 𝑟 𝐿 −𝑟) increases with inflation, and lowers saving and investment in the economy. Lending is discouraged because lenders pay taxes on nominal interest rate, i.e. on real int. rate and inflation rate. 𝒓 𝝅 𝒊
After tax real int. rate for lender ( 𝒓 𝑳 ) 3% 0%
3% 1−0.25 −0%=2.25% 2% 5%
5% 1−0.25 −2%=1.75% 8%
8% 1−0.25 −5%=1%

36. Shoe-Leather Costs 12.3 THE COST OF INFLATION
So-called “shoe-leather” costs arise from an increase in the velocity of circulation of money and an increase in the amount of running around that people do to try to avoid incurring losses from the falling value of money.

37. Confusion Costs 12.3 THE COST OF INFLATION
Money is our measuring rod of value.
Borrowers and lenders, workers and employers, all make agreements in terms of money.
Inflation makes the value of money change, so it changes the units on our measuring rod.

38. Uncertainty Costs 12.3 THE COST OF INFLATION
A high inflation rate brings increased uncertainty about the long-term inflation rate.
Increased uncertainty also misallocates resources.
Instead of concentrating on the activities at which they have a comparative advantage, people find it more profitable to search for ways of avoiding the losses that inflation inflicts.
Gains and losses occur because of unpredictable changes in the value of money.

39. How Big Is the Cost of Inflation?
The cost of inflation depends on its rate and its predictability.
The higher the inflation rate, the greater is its cost.
And the more unpredictable the inflation rate, the greater is its cost.

40. 17
Monetary Policy
CHAPTER CHECKLIST
When you have completed your study of this chapter, you will be able to
1 Describe the objectives of U.S. monetary policy, the framework for achieving those objectives, and the Fed’s monetary policy actions.
2 Explain the transmission channels through which the Fed influences real GDP and the inflation rate.
3 Explain and compare alternative monetary policy strategies.
Notes and teaching tips: So much news-making monetary policy has occurred during the past few years that you will be overwhelmed with options to enliven and make the topic of this chapter relevant to today’s economy. We provide some guidance on slides 9, 10, 11, 13, 14, 16, 31, 38, 47, and 67.
To view a full-screen figure during a class, click the red “expand” button.
To return to the previous slide, click the red “shrink” button.
To advance to the next slide, click anywhere on the full screen figure.
To enhance your lecture, check out the Lecture Launchers, Land Mines, and Class Activities in the Instructor’s Manual.

41. 17.1 HOW THE FED CONDUCTS MONETARY POLICY
The Federal Reserve Act The Federal Reserve Act amendment passed by Congress in 2000 states that: The Board of Governors of the Federal Reserve System and the Federal Open Market Committee shall maintain long-run growth of the monetary and credit aggregates commensurate with the economy’s long-run potential to increase production, … so as to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates. (Dual Mandate)

42. 17.1 HOW THE FED CONDUCTS MONETARY POLICY
Operational “Maximum Employment” Goal
The Fed pays close attention to the business cycle and tries to steer a steady course between recession and inflation.
The Fed tries to minimize the output gap—the percentage deviation of real GDP from potential GDP.
Remind your students that the output gap and the deviation of unemployment from the natural unemployment rate are correlated.

43. 17.1 HOW THE FED CONDUCTS MONETARY POLICY
Operational “Stable Prices” Goal
The Fed believes that core inflation provides the best indication of whether price stability has been achieved.
Core inflation is the annual percentage change in the Personal Consumption Expenditure Price Index (PCEPI) excluding the prices of food and energy.
The Fed has not defined price stability, but many economists regard it as a core inflation rate of between 1 and 2 percent a year.
You can generate a lively classroom discussion on this topic. Is the Fed’s focus on the core measure misplaced? Is the Fed interested only in the welfare of people who don’t eat and drive? On the next slide, you can emphasize that the core measure often is below the overall measure of inflation.

44. 17.1 HOW THE FED CONDUCTS MONETARY POLICY
The Federal Funds Rate
The Fed’s choice of monetary policy instrument is the federal funds rate.
Federal funds rate is the interest rate at which banks can borrow and lend reserves in the federal funds market.
How does the Fed decide the appropriate level for the federal funds rate?
And how, having made that decision, does the Fed move the federal funds rate to its target level?

46. 17.2 MONETARY POLICY TRANSMISSION
When the Fed changes the federal funds rate, events ripple through the economy and lead to the ultimate policy goals.
Quick Overview
Short run:
𝑖 𝑓𝑓 ↓ ⟹ 𝑖↓,$↓ ⟹ 𝐶↑,𝐼↑, 𝑋−𝐼𝑀 ↑ ⟹𝐷𝑒𝑚𝑎𝑛𝑑 𝑓𝑜𝑟 𝑂𝑢𝑡𝑝𝑢𝑡↑
Long run: 𝜋↑
Next figure summarizes the ripple effects.

47. Because the lags are long and variable, monetary policy actions in 2006 and 2007 are the source of how the economy behaved in 2008 and Generate a classroom discussion of whether past policy was too loose or too tight or too variable or too constant.

48. 17.2 MONETARY POLICY TRANSMISSION
Interest Rate Changes
The first effect of a monetary policy decision by the FOMC is a change in the federal funds rate.
Other interest rates then change quickly and relatively predictably.

49. 17.2 MONETARY POLICY TRANSMISSION
Exchange Rate Changes
The exchange rate (price of domestic currency in terms of foreign currency) responds to changes in the interest rate in the United States relative to the interest rates in other countries—the U.S. interest rate differential.
When the Fed lowers the federal funds rate, the U.S. interest rate differential falls and, other things remaining the same, the U.S. dollar depreciates (investors prefer foreign currency bonds).

50. 17.2 MONETARY POLICY TRANSMISSION
Money and Bank Loans
To change the federal funds rate, the Fed must change the quantity of bank reserves, which in turn changes the quantity of deposits and loans that the banking system can create.

51. 17.2 MONETARY POLICY TRANSMISSION
The Long-Term Real Interest Rate
Changes in the federal funds rate change the supply of bank loans, which changes the supply of loanable funds and changes the real interest rate in the loanable funds market.

52. 17.2 MONETARY POLICY TRANSMISSION
Expenditure Plans
A change in the real interest rate changes consumption expenditure, investment, and net exports.
A change in consumption expenditure, investment, and net exports changes aggregate demand.

53. 17.2 MONETARY POLICY TRANSMISSION
About a year after the change in the federal funds rate occurs, real GDP growth changes.
About two years after the change in the federal funds rate occurs, the inflation rate changes.

54. 17.2 MONETARY POLICY TRANSMISSION
Loose Links and Long and Variable Lags
You’ve seen the ripple effects of a change in monetary policy.
To achieve its goals of price stability and full employment, the Fed needs a combination of good judgment and good luck.
The loose links in the chain from the federal funds rate to policy goals make unwanted policy outcomes inevitable.

55. 17.2 MONETARY POLICY TRANSMISSION
Loose Links from Federal Funds Rate to Spending The long-term real interest rate that influences spending plans is linked only loosely to the federal funds rate. Also, the response of the long-term real interest rate to a change in the nominal rate depends on how inflation expectations change. The response of expenditure plans to changes in the real interest rate depends on many factors that make the response hard to predict.

56. 17.2 MONETARY POLICY TRANSMISSION
Time Lags in the Adjustment Process The monetary policy transmission process is long and drawn out. Also, the economy does not always respond in exactly the same way to a given policy change. Further, many factors other than policy are constantly changing and bringing new situations to which policy must respond.

57. 17.2 MONETARY POLICY TRANSMISSION
A Final Reality Check
The time lags in the adjustment process are not predictable, but the average time lags are known.
After the Fed takes action, real GDP begins to change about one year later and the inflation rate responds with a lag that averages around two years.
This long time lag between the Fed’s action and a change in the inflation rate, the ultimate policy goal, makes monetary policy very difficult to implement.

58. 17.3 ALTERNATIVE MONETARY POLICY STRATEGIES
All the possible monetary policy strategies can be place in two broad categories: discretionary and rule-based policy.
Discretionary monetary policy is a monetary policy that sets the central bank’s policy instrument at the level it believes will best achieve its mandated policy goals.
A rule-based monetary policy is one based on a rule for setting the policy instrument.

59. 17.3 ALTERNATIVE MONETARY POLICY STRATEGIES
Two alternative monetary policy rules have been proposed. They are
An interest rate rule
A monetary base rule

60. 17.3 ALTERNATIVE MONETARY POLICY STRATEGIES
Interest Rate Rule: Taylor rule
𝑖 𝑡 = 𝜋 𝑡 + 𝑟 𝑡 ∗ 𝜋 𝑡 − 𝜋 𝑡 ∗ 𝑦 𝑡 − 𝑦 𝑡 ∗ 𝑦 𝑡 ∗ ×100
𝑟 𝑡 ∗ - long-run real interest rate
𝜋 𝑡 ∗ - target inflation rate, 𝜋 𝑡 - actual inflation
𝑦 𝑡 ∗ - potential real GDP, 𝑦 𝑡 - actual RGDP
𝐼𝑛𝑓𝑙𝑎𝑡𝑖𝑜𝑛 𝑔𝑎𝑝
𝑂𝑢𝑡𝑝𝑢𝑡 𝑔𝑎𝑝

61. 17.3 ALTERNATIVE MONETARY POLICY STRATEGIES
Interest Rate Rule: Taylor rule
𝑖 𝑡 = 𝜋 𝑡 + 𝑟 𝑡 ∗ 𝜋 𝑡 − 𝜋 𝑡 ∗ 𝑦 𝑡 − 𝑦 𝑡 ∗ 𝑦 𝑡 ∗ ×100
Suppose that inflation is at its target of 2%, 𝑟 𝑡 ∗ =2%, and there is no output gap, then Taylor rule suggests 𝑖 𝑡 =4%.
If output is 1% below potential, the rule recommends lowering interest rate by 0.5%.
If inflation rate is 1% above the target, the rule recommends increasing interest rate by 1.5%.