David K.H. Begg, Gianluigi Vernasca-Economics-McGraw Hill Higher Education (2011)

Learning Outcomes
By the end of this chapter, you should understand:
0 inflation targets for monetary policy
f) the ii schedule
0 how inflation affects aggregate demand
0 aggregate supply in the classical model
0 the equilibrium inflation rate
0 complete crowding out in the classical model
0 why wage adjustment may be slow
0 short-run aggregate supply
0 temporary and permanent supply shocks
41) how monetary policy reacts to demand and supply shocks
Q) flexible inflation targets
4J) A Taylor rule
Keynesian models suggest that higher aggregate demand always raises output. However, with only finite
resources, the economy cannot expand output indefinitely. We now introduce only aggregate supply -
firms' willingness and ability to produce - and show how demand and supply together determine output.
Aggregate demand reflects the interaction of the markets for goods and money. Aggregate supply reflects
the interaction of the markets for goods and labour.
Introducing supply means that we abandon the simplifying assumption that output is determined by
demand alone. With both supply and demand, we can also explain what determined prices. We no longer
need to assume that prices are given. And since inflation is simply the growth of prices from period to
period, a model of prices is also a model of inflation. This allows us to represent monetary policy as
inflation targeting, the policy rule actually followed by most central banks today.
480