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

United States, monetary policy is the responsibility of the Federal Reserve, our
central bank.
Keeping inflation low and stable is a primary responsibility of any central
bank, and, particularly during the past twenty-five years, many countries have
undertaken central bank reforms that specify low inflation as the major or even
sole objective of monetary policy. To maintain control over inflation, the Fed
needs to keep its eye on the level of aggregate demand relative to the economy’s
full-employment output. If aggregate demand rises relative to the economy’s fullemployment
output, inflation will rise: firms can boost prices and low unemployment
will lead to wage increases in excess of productivity gains that push up
firms’ costs. If demand falls relative to potential output, inflation will eventually
moderate. To keep inflation stable, the Fed acts to reduce demand when it starts
to rise and to increase demand when it falls.
In the previous two chapters, we focused on the first two of the four key concepts
for understanding short-run economic fluctuations—wages and prices do not adjust
fast enough to keep the economy always at full employment. As a result, unemployment
and output fluctuate around the full-employment level, and equilibrium occurs
when output equals aggregate expenditures. In this chapter, we bring into our
analysis the third and fourth key concepts—there is a short-run trade-off between
inflation and unemployment, and increases in inflation reduce aggregate spending.
By the end of the chapter, you will have a simple framework for understanding
many important macroeconomic debates.
The Real Interest Rate and the
Capital Market
Any news report on the Fed and monetary policy is sure to involve a discussion of
interest rates. The reason is simple: central bank policies influence the level of aggregate
demand by affecting the cost and availability of credit. In Chapter 30, we examined
the four components of aggregate expenditures—consumption, investment,
government purchases, and net exports—and their determinants, and we learned
that the real interest rate is one of the main factors influencing aggregate expenditures.
To simplify the analysis in this and the next two chapters, we will concentrate
on the case of a closed economy. This focus enables us to ignore net exports. Despite
the growing importance of international trade, the vast bulk of goods and services
purchased in the United States are produced in the United States, so even an initially
circumscribed analysis can provide important insights into macroeconomics.
In Chapter 35 we will discuss how the lessons learned from a study of a closed
economy need to be modified when we deal with an open economy.
In a closed economy, a higher real interest rate lowers aggregate expenditures
by two primary mechanisms: (1) it reduces the profitability of investment, leading businesses
to scale back investment projects, and (2) it affects consumer loans and mortgages,
causing households to cut back on purchases of new homes and of consumer
durables such as autos.
690 ∂ CHAPTER 31 AGGREGATE DEMAND AND INFLATION