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

stimulate aggregate expenditures, expand output, and moderate
the recession.
We illustrate the connection between inflation and the nominal
interest rate the central bank sets in panel A of Figure 33.6. The real
interest rate is the nominal rate minus inflation, so the nominal interest
rate must rise proportionally more than increases in inflation to
ensure that the real interest rate increases. 4 This means that the
slope of the line in the figure is greater than 1. If the inflation rate
increases from π 0 to π 1 , the nominal interest rate is raised from i 0 to
i 1 . The change in the nominal interest rate, i 1 to i 0 , is greater than
the change in the rate of inflation, π 1 to π 0 .
The relationship between inflation and the interest rate set by
the central bank is an example of the type of monetary policy rule
we introduced in Chapter 31. A policy rule is just a description of
how the central bank behaves. We have assumed that the policy
rule takes a very simple form: the central bank changes the nominal
interest rate in response to changes in inflation. We will discuss
later in this chapter how the central bank may respond to other
macroeconomic variables. Even our simple rule, though, captures
important aspects of actual Fed behavior over the past twenty years.
It implies that the real rate of interest increases as inflation rises,
as shown in panel B of Figure 33.6. Conversely, a fall in inflation leads
to a decline in the real interest rate.
Because the Fed sets a target for the nominal federal funds interest
rate, we have discussed monetary policy in terms of its effects on
interest rates. The relationships shown in panel B would also arise if
the central bank instead targeted the money supply. Such was the
case from 1979 until 1984, while Paul Volcker was chair of the Federal
Reserve; policy focused on target growth rates for measures of bank
reserves and the money supply. As an increase in the inflation rate
drives prices up faster, individuals will need more money on hand to
carry out transactions. The demand for money, including bank deposits,
rises. Banks will need to hold more reserves—at each level of the federal
funds rate, the demand for reserves shifts up. If the Fed holds
the supply of reserves constant, the funds rate will rise. So the policy
rule represented in Figure 33.6 would also hold under a policy focused
on controlling money supply.
The policy rule illustrates how the Fed responds to inflation. If
the Fed reacts to other factors, the line representing the policy rule
will shift. For example, suppose at a given rate of inflation the Fed
decides to lower interest rates, as it did in January 2001 to offset
rising unemployment. This action would shift the entire policy rule downward; at
each rate of inflation, the nominal (and real) interest rate would therefore be lower.
NOMINAL RATE OF INTEREST (i)
REAL RATE OF INTEREST (i)
r 0
i 1
Figure 33.6
r 1
r 0
π 0 π 1
INFLATION (π)
A
The
policy
rule
i 0
π 0 π 1
INFLATION (π)
B
45° line
INTEREST RATES AND INFLATION: THE FED’S
POLICY RULE
To ensure that the real interest rate increases when inflation
rises, the Fed must raise the nominal interest rate
more than proportionally with an increase in inflation. In
panel A, at an inflation rate of π 0 , the central bank sets
the nominal rate equal to i 0 ; the real rate of interest is
r 0 = i 0 −π 0 . If inflation increases to π 1 , the nominal interest
rate increases to i 1 . This increase is greater than the increase
in inflation, so the real rate, shown in panel B, increases as
inflation rises.
4 If nominal interest income is taxed, the nominal rate will need to rise proportionally more than inflation to
ensure that the real, after-tax interest rate rises.
MONETARY POLICY ∂ 741