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

NOMINAL RATE OF INTEREST (i)
B
6%
5%
A
Figure 33.7
2%
INFLATION (π)
THE MONETARY POLICY RULE
AND THE EQUILIBRIUM REAL
INTEREST RATE AT FULL
EMPLOYMENT
The central bank’s policy rule needs to be
consistent with the economy’s equilibrium
real interest rate at full employment and
the central bank’s target inflation rate. If
the equilibrium real interest rate at full
employment is 3 percent and the central
bank’s inflation target is 2 percent, then
the nominal interest rate must be 5 percent
when inflation is equal to its target,
as shown by the policy rule line AA.
If the equilibrium real interest rate
at full employment rises to 4 percent,
the central bank must set the nominal
rate equal to 6 percent when inflation is
on target. The entire policy line shifts
up to BB.
B
A
our hypothetical full-employment economy, must then be 5 percent—the fullemployment
equilibrium real interest rate (3 percent) plus the desired inflation rate
(2 percent). Figure 33.7 shows the policy rule for this example (the line labeled
AA); when inflation is equal to 2 percent, the policy rule shows that the central
bank sets the nominal interest rate equal to 5 percent.
If the equilibrium real rate of interest at full employment changes, the central
bank will need to shift its policy rule. For example, in Chapter 24, we learned that an
increase in the fiscal deficit would increase the equilibrium real interest rate at full
employment. Suppose the full-employment real interest rate rises from 3 percent to
4 percent. Now, when inflation is on target (equal to 2 percent), the central bank must
ensure that the nominal interest rate at full employment is 6 percent—the 4 percent
real rate plus 2 percent for inflation. The monetary policy rule must shift up, as illustrated
by the line labeled BB in Figure 33.7. When the full-employment real interest
rate falls—owing to a reduction in the fiscal deficit or a rise in household saving, for
example—the central bank must shift its policy line down. Thus, the position of the
policy rule will depend on the economy’s full-employment equilibrium real interest rate.
These shifts in the policy rule as the full-employment equilibrium real interest
rate changes are not automatic; the Fed must make an explicit decision to alter its
policy rule. Failure to do so can harm the economy, and some of the policy errors of
the past forty years can be attributed to the Fed’s not adjusting its policy rule when
the full-employment equilibrium real interest rate changed.
The 1960s provide a case in point. As already noted in this chapter, the 1964 tax
cut and the expansion in government spending associated with the Vietnam War
and the War on Poverty pushed the U.S. economy above potential output by the end
of the decade, causing, inflation to start to rise. Figure 33.8 illustrates this situation.
The initial equilibrium, at full employment, is labeled as E 0 . The fiscal expansion
shifted the ADI curve to the right, leading to the economy’s new, short-run equilibrium
at E 1 . As we learned in Chapter 31, the inflation adjustment curve shifts up
when the output gap is positive. Eventually, full employment is restored at E 2 , with
a higher rate of inflation.
The fiscal expansion raised the full-employment equilibrium real interest rate.
In response, to prevent inflation from rising, the Fed should have shifted its policy
rule. At each inflation rate, it should have set a higher interest rate. Doing so would
have counteracted the rightward shift in the ADI curve; as a result, full employment
would have been restored at E 0 , with both output and inflation returning to their
original levels.
This simple statement of what the Fed should have done ignores an important
complication: the equilibrium real rate of interest cannot be directly observed by
economists. The Fed must try to estimate the equilibrium real rate, a task that can
be difficult. Thus even if the Fed recognizes the need to adjust its policy rule, it may
not know by how much. For example, tax cuts and expenditure increases that took
place between 2001 and 2004 are projected to lead to huge fiscal deficits over the
next several years. These deficits will increase the equilibrium real interest rate.
But the effects of the deficits will depend on how the president and Congress eventually
adjust taxes and expenditures to deal with the deficit and on when those
adjustments are made.
746 ∂ CHAPTER 33 THE ROLE OF MACROECONOMIC POLICY