[Joseph_E._Stiglitz,_Carl_E._Walsh]_Economics(Bookos.org) (1)

Chapter 31
AGGREGATE
DEMAND AND
INFLATION
∂
Every six weeks, the members of the Federal Open Market Committee
(FOMC), the policymaking committee of the Federal Reserve, gather in
Washington, D.C. They come from across the nation to discuss the state of
the economy and to make decisions that can determine the outlook for U.S. inflation
and unemployment over the next several years. Stock markets can rise or fall
in anticipation of FOMC decisions. On April 14, 2000, when the government released
the latest figures suggesting a rise in inflation, the Dow Jones Industrial Average
fell 616 points, its largest one-day point loss ever, in response to investors’ fears that
the FOMC would raise interest rates. Nine months later, on January 3, 2001, the
Dow jumped 300 points and the NASDAQ went up 325 points when the FOMC cut
interest rates. Investors know that if the economy booms and inflation rises, the Fed
will increase interest rates; if the economy slows and inflation falls, the Fed will
lower interest rates. These decisions by the FOMC affect the cost of credit for major
corporations as well as for small family businesses. They affect the cost of car loans,
student loans, and home mortgages. The importance of the FOMC for everyone in
the economy has spawned a distinct industry of “Fed watchers” who try to predict
what the FOMC will do. Since 1986, the chair of the Federal Reserve has been Alan
Greenspan, and Fed watchers closely follow every speech and statement made by
Chairman Greenspan for clues about future policy actions.
The Fed’s actions have an important influence on GDP and inflation. In Chapter
30, we learned that the economy’s level of output (GDP) is determined in the short
run by the level of aggregate demand. One factor that affects aggregate demand
is the real rate of interest. We now need to bring inflation back into the picture so
that we can understand the linkages among inflation, the real interest rate, and
aggregate demand. Monetary policy plays a critical role in this story. This should
not be surprising, for Chapter 28 has already noted that when the economy is at full
employment, the average inflation rate is determined by monetary policy. In the
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