Modern Macroeconomics.pdf

426 Modern macroeconomicsFor simplicity, if we assume that the central bank’s choice of real interestrate depends entirely on its inflation objective, the monetary policy (MP) realrate rule can be shown as a horizontal line in panel (a) of Figure 7.15, withshifts of the MP curve determined by the central bank’s reaction to changesin the rate of inflation. Equation (7.20) is represented by the IS curve inFigure 7.15. In panel (b) of Figure 7.15 we see equation (7.23) illustrated bya downward-sloping aggregate demand curve in inflation–output space. Theintuition here is that as inflation rises the central bank raises the real rate ofinterest, thereby dampening total expenditure in the economy and causingGDP to decline. Similarly, as inflation falls, the central bank will lower thereal rate of interest, thereby stimulating total expenditure in the economy andraising GDP. We can think of this response as the central bank’s monetarypolicy rule (Taylor, 2000b).Shifts of the AD curve would result from exogenous shocks to the variouscomponents to aggregate expenditure, for example the AD curve will shift tothe right in response to an increase in government expenditure, a decrease intaxes, an increase in net exports, or an increase in consumer and/or businessconfidence that leads to increased expenditures. The AD curve will also shiftin response to a change in monetary policy. For example, if the monetaryauthorities decide that inflation is too high under the current monetary policyrule, they will shift the rule, raise real interest rates and shift the AD curve tothe left (see Taylor, 2001).The Phillips curve or inflation adjustment relationship, given by equation(7.22), is represented by the horizontal line labelled IA 0 in Figure 7.16. FollowingTaylor (2000b) and D. Romer (2000), this can be thought of as the aggregatesupply component of the model, assuming first that the immediate impact of anincrease in aggregate demand will fall entirely on aggregate output, and secondthat when actual GDP equals potential or ‘natural’ GDP (y = y * ), inflation willbe steady, but when y > y * , inflation will increase and when y < y * , inflation willdecline. Both of these assumptions are consistent with the empirical evidenceand supported by new Keynesian theories of wage and price stickiness in theshort run (Gordon, 1990). When the economy is at its potential output the IAline will also shift upwards in response to supply-side shocks such as a rise incommodity prices and in response to shifts in inflationary expectations. Figure7.16 illustrates the complete AD–IA model.Long-run equilibrium in this model requires that AD intersect IA at thenatural rate of output (y * ). Assume that the economy is initially in long-runequilibrium at point E LR 0 and that an exogenous demand shock shifts the ADcurve from AD 0 to AD 1. The initial impact of this shift is an increase in GDPfrom y * to y 1 , with inflation remaining at P˙ 0 . Since y 1 > y * , over time the rateof inflation will increase, shifting the IA curve upwards. The central bank willrespond to this increase in inflation by raising the real rate of interest, shown