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

These actions were taken in light of further weakening of the sales and production,
and in the context of lower consumer confidence, tight conditions in some segments
of financial markets, and high energy prices sapping household and business
purchasing power. Moreover, inflation pressures remain contained. . . .
CONSEQUENCES OF INFLATION TARGETING
Even a central bank that has adopted a formal inflation target still must make important
policy choices. We can use the ADI framework to understand these policy tradeoffs.
Figure 38.3A shows two monetary policy rules. For both, the central bank’s
target for the inflation rate is π T and the full-employment equilibrium real interest
rate is r * . When the economy is at full employment and inflation is on target, the
nominal interest rate set by the central bank will be i * = r * +π T . The policy rule
labeled A is steeper than the one labeled B. If policy is set using rule A, a rise in inflation
leads the central bank to boost interest rates by a larger amount than it would
NOMINAL INTEREST RATE (i)
i 1
A
i 1
B
i*
π T
A
B
π 1
INFLATION (π)
A
INFLATION (π)
E A E B
π T E 0
Y *
OUTPUT (Y )
B
ADI A
ADI B
Figure 38.3
THE POLICY RULE AND
FLUCTUATIONS
The way the central bank responds to inflation affects the slope of the ADI curve, and
this in turn has important effects on how the economy responds to disturbances. Panel A
shows two policy rules. Under rule A, changes in inflation lead to larger changes in the
real interest rate than is the case under rule B. If inflation rises from π T to π 1 , the nominal
interest rate is increased to i A 1 under rule A and only to iB 1
under rule B. Since as a result
the real interest rate changes more under rule A, a change in inflation has a bigger
impact on aggregate demand than with rule B. As a consequence, the ADI curve with
rule A is flatter than the one under rule B (see panel B). An inflation shock, as in panel B,
leads to a bigger fall in output under rule A. Output will vary more and inflation less with
rule A than with rule B.
SHOULD THE FEDERAL RESERVE TARGET INFLATION? ∂ 853