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

The Inflation Target The position of the monetary policy rule also depends
on the central bank’s target inflation rate. As we just learned, at full employment
the central bank will set the nominal interest rate equal to the equilibrium real
interest rate plus the target for the rate of inflation. Suppose the central bank decides
to lower its inflation target from 2 percent to 1 percent. And let’s assume the
full-employment equilibrium real interest rate is 3 percent. Figure 33.9 depicts the
initial policy rule, the one for a target inflation rate of 2 percent, as AA. When inflation
is equal to the target, the nominal interest rate is 5 percent (the 3 percent real
interest rate plus 2 percent inflation). When the inflation target is reduced to 1 percent,
the nominal interest rate at full employment falls from 5 percent to 4 percent
(the 3 percent real interest rate plus the new target inflation rate of 1 percent). The
policy rule shifts up to BB, as illustrated in the figure. At each rate of inflation, the
nominal rate is now set at a higher value.
Aggregate
demand-inflation
curves
Potential
output
INFLATION (π)
ADI 1
ADI 0 E 2
E 0 E 1
Inflation
adjustment
line
OUTPUT (Y )
Figure 33.8
A FISCAL EXPANSION WHEN
THE FED’S POLICY RULE DOES
NOT ADJUST AND WHEN
IT DOES
The figure illustrates the consequences if the Fed fails to adjust its policy rule when the
equilibrium real interest rate at full employment changes. A fiscal expansion shifts the
aggregate demand–inflation curve from ADI 0 to ADI 1 . In the short run, equilibrium
output rises and the new equilibrium is at E 1 . If the Fed does not adjust its policy rule,
the economy eventually returns to full employment at E 2 with higher inflation. The
green arrows show the path the economy takes. To prevent the fiscal expansion from
leaving inflation higher, the Fed must raise interest rates at a given rate of inflation.
This shift in the Fed’s policy rule is necessary because a fiscal expansion raises the real
interest rate that balances the capital market at full employment. If the Fed’s policy
rule shifts, then the ADI curve is shifted back to ADI 0 , the economy returns to full
employment, and inflation returns to its initial level at E 0 along the black arrow.
MONETARY POLICY ∂ 747