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
• 12.10 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.