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

21. l Inflation and aggregate demand
To get started, we swap the Keynesian extreme, with fixed wages and prices, for the
opposite extreme, full wage and price flexibility.
In the classical model, the economy is always at full capacity. Any deviation of
output from full capacity causes instant price and wage changes to restore output
to potential output. In the classical model, monetary and fiscal policies affect prices
but not output, which is always at potential output.
The classical model of
macroeconomics assumes
wages and prices are
completely flexible.
In the short run, until prices and wages adjust, the Keynesian model is relevant. In the long run, once all
prices and wages have adjusted, the classical model is relevant. We study how the economy evolves from
the Keynesian short run to the classical long run.
Inflation and aggregate demand
If a central bank behaves predictably, its behaviour can be modelled. Chapter 20
explained why the growing instability of money demand led central banks to abandon
monetary targeting. Nowadays, most central banks pursue an inflation target.
Target inflation n* varies from country to country, but is usually around 2 per cent
a year. Why not a target of zero inflation? Policy makers are keen to avoid deflation
(negative inflation), which can become a black hole. Even if the nominal interest
rate r is reduced to zero, the real interest rate i, which is simply (r-n), can be large
if inflation n is large but negative.
In turn, high real interest rates cause further contraction and make inflation more
negative still, making real interest rates even higher. If nominal interest rates have already
been reduced to zero, monetary policy can do nothing further to combat shrinking
aggregate demand. To avoid this black hole, setting a positive inflation target leaves
Inflation is the growth rate
of the price level of aggregate
output.
With an inflation target, the
central bank adjusts interest
rates to try to keep inflation
close to the target inflation rate.
Under inflation targeting, the ii
schedule shows that at higher
inflation rates the central bank
will wish to have higher real
interest rates.
a margin of error. If inflation today is 2 per cent and an unforeseen shock reduces inflation by 1 per cent, there
is still time for the central bank to act to boost the economy before it gets too close to a deflationary spiral.
Figure 21.1 shows how monetary policy works when interest rates are set in pursuit of an inflation target.
When inflation is high, the central bank ensures that real interest rates are high, which reduces aggregate
demand, putting downward pressure on inflation.
With a vertical ii schedule, inflation would be completely stabilized at its target rate n*. If inflation started
to rise, real interest rates would be raised by whatever was necessary to restore inflation to its target level.
When inflation is above (below) the target
n*, real interest rates are set higher (lower)
than normal. Along the schedule ii, a given
monetary policy is being pursued. If the
inflation target is n*, the corresponding real
interest rate wi 11 be i*.
1t
Inflation rate
Figure 21.1
Interest rates and inflation targeting
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