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

International Perspective
HOW DO OTHER CENTRAL BANKS REACT TO INFLATION?
The reaction of the central bank to inflation is a critical factor
in determining the slope of the ADI curve. One implication of
the bank’s role is that ADI curves in different countries may
have different slopes, because central banks do not all react
to inflation in the same way. Countries whose central bank
responds aggressively to inflation, pushing up interest rates at
its slightest hint and cutting interest rates whenever it falls
below target, will have flatter ADI curves than will countries
with central banks that fail to react to changes in inflation.
Three economists—Rich Clarida of Columbia and Jordi
Galí and Mark Gertler of New York University—have estimated
how various central banks respond to inflation. For the
Federal Reserve, the German Bundesbank (prior to the formation
of the European Economic and Monetary Union), and
the Bank of Japan, they find strong evidence consistent with
the type of policy rule we have used to represent monetary
policy. When inflation increases, these central banks raise
nominal interest rates by more than that increase. If inflation
rises by 1 percentage point, the nominal interest rate must
rise by more than 1 percentage point to ensure that the real
interest rate rises. When inflation falls, these central banks
reduce the nominal interest rates by more so that the real
interest rate falls.
Yet despite their similar responses to inflation, Clarida,
Galí, and Gertler also found some differences among these
central banks. Of the three, the Bank of Japan was judged to
respond the most strongly to changes in inflation, while the
Bundesbank showed the weakest reaction. From what we have
learned about the factors that affect the slope of the ADI curve,
these differences in policy rules among Germany, Japan, and
the United States mean that the slopes of each country’s ADI
curve will differ. Japan’s response to inflation, because it is
stronger, should produce a flatter ADI curve than Germany’s.
However, we also learned that the policy rule is not the only
factor that affects the ADI slope, so we would also need to
know how sensitive spending in each country is to changes in
the real interest rate before we could make a final prediction
about how their ADI slopes might differ.
Monetary policy rules can change over time. In the 1960s
and 1970s, most central banks did not react as aggressively
to inflation as they do today. Because inflation reached
undesirable levels in the 1970s, central banks today focus on
ensuring that inflation remains low and stable.
SOURCE: R. Clarida, J. Galí, and M. Gertler, “Monetary Policy Rules in Practice:
Some International Evidence,” European Economic Review 42, no. 6 (1998): 1033–1068.
OTHER FACTORS THAT CAN SHIFT THE
ADI CURVE
While fiscal policy and monetary policy are key factors that can shift the ADI curve,
similar effects occur if investment or consumption behavior changes at each value
of the inflation rate. For example, the stock market boom of the 1990s boosted consumption
spending for given levels of income and inflation. This type of wealth effect
on consumption spending increases total aggregate expenditures and the equilibrium
level of output. Greater optimism about the future can encourage consumption and
investment spending, also increasing aggregate expenditures. For a given level of
the inflation rate, equilibrium output would be higher, an outcome represented by
a rightward shift of the ADI curve.
If households and firms become more pessimistic about the future and scale
back their spending, or if wealth falls because of a stock market collapse, for example,
aggregate expenditures would fall at each level of the inflation rate. The result
is a leftward shift in the ADI curve.
696 ∂ CHAPTER 31 AGGREGATE DEMAND AND INFLATION