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

NOMINAL RATE OF INTEREST (i)
5.5%
5%
4%
BB
AA
45° line
This shift in the policy rule does succeed in lowering inflation.
If the economy initially has 2 percent inflation, the central bank
increases the nominal interest rate in line with the new policy rule
BB. As shown in the figure, the nominal rate rises to 5.5 percent.
Since inflation is still equal to 2 percent, this represents a rise in the
real interest rate from 3 percent to 3.5 percent, which dampens
aggregate spending and causes output to decline in the short run.
The decline puts downward pressure on inflation. The economy
suffers an increase in cyclical unemployment in the short run, but
eventually full employment is restored at a lower rate of inflation.
THE SLOPE OF THE POLICY RULE
Figure 33.9
1% 2%
INFLATION (π)
THE EFFECT OF A SHIFT IN THE INFLATION
TARGET ON THE CENTRAL BANK’S
POLICY RULE
The position of the monetary policy rule depends on the
central bank’s target for inflation. Policy rule AA is based
on an inflation target of 2 percent and an equilibrium real
interest rate of 2 percent at full employment. If the central
bank reduces its inflation target to 1 percent, the policy
rule shifts up. At a given inflation rate, the central bank will
set nominal interest rates higher.
The slope of the monetary policy rule tells us how much the central
bank adjusts interest rates when inflation changes. Suppose the central
bank reacts aggressively to inflation, hiking interest rates whenever
inflation rises and cutting them sharply whenever it falls. Such
behavior would be represented by a policy rule that has a steep slope,
indicating that changes in inflation lead to large changes in interest
rates. In contrast, the policy rule for a central bank that reacts more
moderately to changes in inflation would be relatively flat. Many
central banks react more strongly to inflation today than they did
in the 1970s. Therefore, we would draw a steeper policy rule to reflect
current practices of central banks than we would if we wanted to
represent their behavior in the 1970s.
The slope of the policy rule is important because, as we learned
in Chapter 31, it helps determine the slope of the ADI curve. If the central
bank reacts aggressively to changes in inflation, aggregate expenditures
will vary more as inflation changes; the ADI curve will be
relatively flat. If the central bank has little response as inflation changes, then aggregate
expenditures will be less affected by inflation and the ADI curve will be steeper.
The slope of the ADI curve significantly affects how the economy responds to
inflation shocks. As we learned in Chapter 31, a positive inflation shock causes
inflation to increase and output to decline in the short run by an amount that
depends on how much aggregate expenditures fall. If the ADI curve is steep—
either because changes in inflation lead to little change in interest rates or because
changes in interest rates induce little change in aggregate spending—the impact
of an inflation shock on output will be small. Because the rise in cyclical unemployment
is small in this case, the moderating effects of a recession on wage growth
and inflation are small, and it may take longer for inflation to return to its initial
level. If the ADI curve is flat—either because changes in inflation lead to large
changes in interest rates or because changes in interest rates induce large changes
in aggregate spending—the impact of an inflation shock on output will be larger.
But because cyclical unemployment increases more in the latter case, the downward
pressures on wage growth and inflation are larger, and the initial rise in
inflation is likely to be reversed more quickly.
748 ∂ CHAPTER 33 THE ROLE OF MACROECONOMIC POLICY