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

INFLATION (π)
π 2
E f
π 0
Y 1
Y f Y 0
π 1
OUTPUT (Y )
Figure 31.2
EQUILIBRIUM OUTPUT AND THE ADI CURVE
For each rate of inflation, the ADI curve shows the economy’s
equilibrium level of output. If inflation is π 0 , the
equilibrium output level is Y 0; at Y 0 , aggregate expenditures
equal output. At a higher inflation rate such as π 1 ,
the real interest rate is higher, aggregate expenditures
are lower, and the equilibrium level of output is only Y 1 .
The vertical line at Y f denotes full-employment output.
THE FED’S POLICY RULE
The Fed is concerned about inflation, and it knows that as unemployment falls, inflation
tends to rise (our third key concept). As inflation rises, the Fed acts to reduce
aggregate demand in order to slow the economy down and lessen any upward pressure
on inflation. The Fed can affect aggregate demand by influencing the real interest
rate. An increase in the real interest rate will reduce investment spending,
for example. As inflation falls, the Fed acts to lower the real interest rate to boost
aggregate expenditures. These changes in aggregate demand move the economy’s
equilibrium level of output.
The Fed’s systematic reaction to the economy is called a monetary policy rule.
It describes how the Fed moves the interest rate in response to economic conditions.
Initially, we will assume a very simple policy rule: the Fed raises interest rates
when inflation increases and lowers interest rates when inflation falls. In 2004, for
example, the Fed was concerned that inflation was rising, so it raised interest rates.
In actuality, the Fed doesn’t react only to inflation—a financial crisis might cause
the Fed to lower interest rates even though inflation is unchanged, the Fed might
be concerned that economic growth is slowing, and so on. For instance, on January
3, 2001, when the FOMC cut its interest rate target, it explained that “these actions
were taken in light of further weakening of sales and production, and in the context
of lower consumer confidence, tight conditions in some segments of financial markets,
and high energy prices sapping household and business purchasing power.
Moreover, inflation pressures remain contained.”
When the Fed responds to factors other than inflation, the policy
rule linking the interest rate to inflation changes. A given policy rule
reflects the adjustment of interest rates to inflation; a change in the policy
rule occurs when, at a given level of inflation, the Fed sets a different
interest rate than before. Because the monetary policy rule describes
how a central bank behaves, it can change over time. In the United
States, as noted in Chapter 29, the Fed has taken much stronger action
against inflation during the past twenty years than it did in the 1960s
and 1970s.
There is one more point to keep in mind. Aggregate expenditures
depend on the real interest rate (i.e., the nominal interest rate adjusted
for inflation). To influence it, the Fed must move the nominal interest
rate in the same direction as inflation, but by more. Thus, if inflation
rises by 1 percentage point—say, from 3 to 4 percent—the Fed must
raise the nominal interest by more than 1 percentage point to increase
the real interest rate. Only then can it affect the real rate of interest
and aggregate spending. To simplify our analysis here, we will postpone
discussing the details of how the Fed affects the nominal interest
rate until Chapter 32.
Inflation and Aggregate Expenditures Our discussion of
the Fed’s policy rule leads to the following conclusion: there is a negative
relationship between inflation and aggregate expenditures.
692 ∂ CHAPTER 31 AGGREGATE DEMAND AND INFLATION