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 In this chapter, we learn:
 in the presence of a systematic monetary policy, we can combine
the IS curve and the MP curve to get an aggregate demand (AD)
curve.
 the Phillips curve can be reinterpreted as an aggregate supply (AS)
curve.
 the AD and AS curves represent an intuitive version of the shortrun model that describes the evolution of the economy in a single
graph.
 modern theories that underlie monetary policy, including the
debate over rules versus discretion and the importance of
expectations.
 If we could formulate a systematic policy in response to the
various kinds of shocks that can possibly hit the economy, what
would the policy look like?
Monetary Policy Rules and Aggregate Demand
 The short-run model consists of three basic equations:
 The short-run model implies that high short-run output leads to an increase in
inflation.
 By choosing the real interest rate, the central bank chooses how to make this tradeoff.
 A monetary policy rule is a set of instructions that determines the stance of monetary
policy for a given situation that might occur in the economy.
 If inflation is above the target, the real interest rate should be high.
 If inflation is below the target, the real interest rate should be low.
 The parameter
governs how aggressively monetary policy responds to inflation.
The AD Curve
 We can substitute the monetary policy rule into the IS curve.
 The resulting equation is the aggregate demand (AD) curve, which says short-run
output is a function of the rate of inflation:
 The AD curve describes how the central
bank chooses short-run output based on
the rate of inflation.
 If inflation is above target, then the
central bank raises the interest rate to
lower output below potential.
 We call it the AD curve is because it is
built up from the demand side of the
economy – consumption, investment,
government purchases, and foreign
demand are essential parts of the curve.
 A change in inflation is a movement along
the AD curve because inflation is on the
vertical axis.
 The monetary policy rule dictates the
central bank increase the interest rate if
inflation is above the target.
 This reduces investment spending and
reduces short-run output by a multiple
of the reduction in investment spending.
 AD is flatter (output responds more
strongly to deviations of inflation from the
central bank’s target) when the CB is more
aggressive – parameter m is greater – and
when investment is more sensitive to the
real interest rate – parameter b is greater.
 Temporary shocks to aggregate demand
parameter, a, and changes in the central
bank’s target inflation rate, π, shift AD.
Aggregate Supply
 The aggregate supply (AS) curve is the price-setting equation used by firms:
 The AS curve is simply the Phillips curve with a new name.
 Since the relationship between the current rate of inflation and short-run
output is upward-sloping, it’s natural to call it an aggregate supply curve.
 The point in the AS graph where shortrun output equals zero is equal to the
inflation rate in the previous period.
 If the inflation rate is changing over
time, the AS curve will shift over time.
 Inflation in the previous period, πt-1, is
the expected rate of inflation in the
current period, πte
 The curve also shifts due to the inflation
shocks parameter, o.
The AS/AD Framework
 Combining the AS and AD curve gives us a dynamic model with two equations and
two unknowns: the inflation rate, πt-1, and short-run output
The Steady State
 In the steady state, endogenous variables R, π, and Y are constant over time and
there are no shocks to the economy.
 In steady state, the inflation rate must be constant.
 Short-run output is equal to zero in the steady state…otherwise the inflation rate
would change.
 Actual output equals potential output in the steady state.
 The inflation rate equals the central bank’s target in the steady state… otherwise
the central bank would change R, change Y and move π toward its target.
 The AD curve slopes downward because
of the response of policymakers to
inflation.
 If inflation is high, the monetary
policy rule dictates increasing the
interest rate.
 This reduces output by lowering
investment demand.
 The AS curve slopes upward as an
implication of price-setting behavior of
firms embodied in the Phillips curve.
 When actual output is above potential,
firms raise their prices by more than
the usual amount to cover higher
wages and other production costs.
An Inflation Shock
 The economy begins in steady state and is hit
with a lasting increase in the price of oil.
 Mathematically, o, is positive for one period
but this inflation shock raises the price level
permanently.
 The AS curve shifts up as a result.
Response
The monetary policy rule dictates that the increase
in inflation be fought by an increase in the real
interest rate – reducing short-run output.
•Stagflation results
•In the next period, o returns to normal, but the
AS curve does not shift back to its initial position:
the rate of inflation in the previous period is now
some value above the target rate of inflation: π1 >
π0 = π
 Movement of the AS curve follows the
principle of transition dynamics – movement
back to the steady state is fastest when the
economy is furthest from its steady state.
 High inflation created by the oil
shock raises expected inflation and
because of sticky inflation, these
expectations adjust slowly.
 This slows the adjustment of the AS
curve back to its initial position.
 The slumping economy leads
inflation to fall, but only slowly.
 Eventually the model will return to
its original steady state.
In summary, the impact of a price shock
is that:
It raises inflation directly.
Even if the shock lasts for a single
period, the shock raises expected
inflation and inflation remains higher
for a longer period of time.
It takes a prolonged slump to get
these expectations back to normal
and the economy suffers stagflation.
Disinflation
Suppose the economy begins in steady state and
policymakers decide to lower the target rate of
inflation to π’.
 The AD curve shifts down:
 at any given inflation rate, the output level
associated with the policy rule is reduced.
 π must now be lower for short-run output to
equal zero as it initially does.
 The new rule calls for an increase in interest rates,
causing a slowdown in inflation to somewhere
between the old one and the new target.
 The economy must now move to its new steady state
by the principle of transition dynamics.
 The change in the rate of inflation causes the AS
curve to shift during the following period.
 Firms adjust their expectation for inflation to account
for the new lower inflation rate and the AS curve
shifts down
 As the inflation rate is still above the target, the
 If the classical dichotomy holds in the short
central bank keeps actual output below potential and
run, the AD and AS curves would reach the
the inflation rate falls further.
new steady state immediately.
 Eventually, the economy rests in its new steady state.
 If there is sticky inflation, a recession is
needed to adjust expectations down.
A Positive AD Shock  Suppose there is a temporary increase in the aggregate
demand parameter .
 The AD curve will shift out such that at any given level of
inflation, output increases.
 Increased demand will result in prices increasing.
 As inflation has increased, firms expect higher inflation in
the future so the AS curve shifts upward over time.
 The inflation rate associated with zero short-run output
rises.
 The AS curve shifts by the principle of transition
dynamics until the economy has higher inflation and zero
short-run output.
The inflation rate now exceeds its steady state by an amount
depending on the aggregate demand shock
Aggregate demand shocks are temporary because the
consumption, investment, government purchases, and net
exports shares of potential output must sum to one.
Thus, when the shock ends, the AD curve shifts back to its
original position – which is like a negative shock because
short-run output was already at 0.
 The boom is followed by recession…why bother?
Counterclockwise Loops
 When plotting inflation on the vertical axis and output on the horizontal axis,
the economy will follow counterclockwise loops to shocks in the economy.
 Positive short-run output leads to rising inflation.
 A rise in inflation leads policymakers to reduce output.
Predicting the Fed Funds Rate
 The Fisher equation allows us to write the monetary
policy rule in terms of the nominal interest rate:
 The Taylor rule suggests picking parameter values
that are functions of 2.
 The simple monetary policy rule provides an accurate
picture of the federal funds rate – except during the
1970s.
Further Thoughts on Aggregate
Demand Shocks
 In theory, monetary policy can be used to insulate an
economy from aggregate demand shocks.
 The monetary policy rule we specified here responds
only to inflation and not output changes.
CHAPTER 12 Stabilization Policy and the AS/AD Framework
Case Study: Real Business Cycle
Models and the “New Economy”
 Variations in TFP can produce realistic fluctuations
in the economy.
 Real business cycles are fluctuations in the economy
that are driven by real forces in the economy.
CHAPTER 12 Stabilization Policy and the AS/AD Framework
 An unresolved issue is whether fluctuations in GDP
are due mostly to fluctuations in potential output or
due to fluctuations in actual output.
 Was the new economy a technological shock that
changed potential output (thus not threatening to
raise inflation) or an aggregate demand shock that
would increase inflation?
 Greenspan attributed most gains in output to
technological change.
CHAPTER 12 Stabilization Policy and the AS/AD Framework
11.6 Empirical Evidence
 What are the empirical predictions of the short-run
model when monetary policy is dictated by an
inflation-based policy rule?
CHAPTER 12 Stabilization Policy and the AS/AD Framework
Predicting the Fed Funds Rate
 The Fisher equation allows us to write the monetary
policy rule in terms of the nominal interest rate:
 The Taylor rule suggests picking parameter values
that are functions of 2.
 The simple monetary policy rule provides an accurate
picture of the federal funds rate – except during the
1970s.
CHAPTER 12 Stabilization Policy and the AS/AD Framework
CHAPTER 12 Stabilization Policy and the AS/AD Framework
Inflation-Output Loops
 When plotting inflation on the vertical axis and output on the horizontal
axis, the economy will follow counterclockwise loops to shocks in the
economy.
 Positive short-run output leads to rising inflation.
 A rise in inflation leads policymakers to reduce output.
CHAPTER 12 Stabilization Policy and the AS/AD Framework
 Empirically, when the economy booms inflation
increases and the central bank slows, the economy
resulting in counterclockwise loops in the data.
CHAPTER 12 Stabilization Policy and the AS/AD Framework
Case Study: Forecasting and the
Business Cycle
 To conduct economic forecasts, economists study a
large number of variables of leading economic
indicators – including the fed funds rate, the term
structure for interest rates, claims for unemployment
insurance, and the number of new houses.
 Professional forecasts have a difficult time predicting
“turning points.”
CHAPTER 12 Stabilization Policy and the AS/AD Framework
CHAPTER 12 Stabilization Policy and the AS/AD Framework
12.7 Modern Monetary Policy
 The Federal Reserve does not officially follow a
monetary policy rule.
 The U.S. economy is much more complicated than
the simple model.
 The short-run model captures many features of
monetary policy as central banks are now more
explicit about policies and targets.
 Inflation rates in industrialized countries have been
well behaved for the last 25 years.
CHAPTER 12 Stabilization Policy and the AS/AD Framework
CHAPTER 12 Stabilization Policy and the AS/AD Framework
More Sophisticated Monetary
Policy Rules
 Richer monetary policy rules that account for shortrun output create results that resemble the simple
model we constructed.
 The simple policy rule we used implicitly weights
short-run output.
 In our model, changes in short-run output lead to
changes in inflation and the monetary policy rule
responds to the changes in inflation – and thus
implicitly, output.
CHAPTER 12 Stabilization Policy and the AS/AD Framework
Rules versus Discretion
 Is there any benefit to creating a systematic policy?
 The time consistency problem suggests that even
though an agent supports a particular policy, once the
future comes, they have incentives to renege on their
promises.
CHAPTER 12 Stabilization Policy and the AS/AD Framework
 After firms and workers form expectations about
inflation and build them into pricing decisions,
central bankers have incentives to pursue an
expansionary policy.
 However, firms and workers anticipate the policy and
build that anticipation into prices – resulting in no
benefit to output.
 If policymakers can commit to not exploiting
inflation expectations, the economy can benefit from
a lower average rate of inflation.
CHAPTER 12 Stabilization Policy and the AS/AD Framework
The Paradox of Policy and Rational
Expectations
 The goal of macroeconomic policy is full
employment, output at potential, and low, stable
inflation.
 The presence of a policymaker willing to generate a
large recession (raises interest rates sharply) to fight
inflation makes use of the policy less likely.
CHAPTER 12 Stabilization Policy and the AS/AD Framework
 Under adaptive expectations, we assume that
expected inflation equals inflation in the previous
period and does not change when the monetary
policy rule changes:
 Our motivation for this assumption was the stickiness
of inflation.
CHAPTER 12 Stabilization Policy and the AS/AD Framework
 Rational expectations says that people use all
information at their disposal to make their best
forecast of the rate of inflation.
 This information may include the costs resulting in
sticky inflation, but may also add the target rate of
inflation.
CHAPTER 12 Stabilization Policy and the AS/AD Framework
 Under rational expectations, the central bank’s
willingness to fight inflation is a key determinant of
expected inflation.
 If firms know the bank will fight aggressively to keep
inflation low, they are less likely to raise prices after
an inflation shock.
 To the extent that policymakers can influence
expectations, they can reduce the costs of
maintaining a low target level of inflation.
CHAPTER 12 Stabilization Policy and the AS/AD Framework
Managing Expectations in the
AS/AD Model
 We can drop the assumption of adaptive expectations
and rewrite the AS curve in terms of the expected
rate of inflation:
CHAPTER 12 Stabilization Policy and the AS/AD Framework
 If the Federal Reserve lowers the inflation target,
then:
The AD curve shifts down.
If expectations adjust immediately and people use all
information, the AS curve shifts down immediately
to the new target.
 To the extent that the central bank can coordinate
people’s expectations of inflation, it can maintain low
and stable inflation without the need for recessions.
CHAPTER 12 Stabilization Policy and the AS/AD Framework
CHAPTER 12 Stabilization Policy and the AS/AD Framework
Case Study: Rational Expectations
and the Lucas Critique
 The Lucas critique says that it is inappropriate to
build a macroeconomic model based on equations in
which expectations are not consistent with the
statistical properties of the economy.
 Models should incorporate the theory of rational
expectations.
CHAPTER 12 Stabilization Policy and the AS/AD Framework
Inflation Targeting
 In many countries, central banks have an explicit
target rate of inflation that they seek to apply over the
medium horizon.
 Explicit inflation targets anchor inflation
expectations.
 This may make it easier for central banks to stimulate
output.
CHAPTER 12 Stabilization Policy and the AS/AD Framework
 Constrained discretion is the idea that a central bank
has the flexibility to respond to shocks in the shortrun, but remains committed to a particular rate of
inflation in the long run.
CHAPTER 12 Stabilization Policy and the AS/AD Framework
Case Study: Choosing a Good
Federal Reserve Chair
 The Romer and Romer study argues that
policymakers’ views about how the economy works
play a crucial role in making a good chair.
 Knowledge of macroeconomics is essential to
successful Fed chairs.
CHAPTER 12 Stabilization Policy and the AS/AD Framework
Conclusion
 A credible, transparent commitment to a low rate of
inflation is one of the key factors in taming inflation.
 Such a commitment anchors inflation expectations so
that shocks are deflected quickly.
CHAPTER 12 Stabilization Policy and the AS/AD Framework
 Commitment to low inflation makes it easier to
stabilize the economy.
 The period after the 1980-82 recession is known as
the Great Moderation because of the relative stability
of the macroeconomy during this time.
CHAPTER 12 Stabilization Policy and the AS/AD Framework
Summary
 Monetary policy often follows a systematic approach
that can be characterized as a monetary policy rule.
In the simple rule explored in this chapter,
, the central bank increases the
real interest rate whenever inflation exceeds a
particular target. Although it’s difficult to imagine
such a simple rule reflecting the real world, it turns
out to describe monetary policy in the U.S. economy
over the last few decades reasonably well.
CHAPTER 12 Stabilization Policy and the AS/AD Framework
 Combining a monetary policy rule with the IS curve leads
to an aggregate demand (AD) curve, which describes how
the central bank chooses the level of short-run output based
on the current rate of inflation.
 The aggregate supply (AS) curve, another name for the
Phillips curve, tells us that the current rate of inflation
depends positively on short-run output. A booming
economy leads firms to raise their prices by more than last
period’s rate of inflation, leading to an even higher rate of
inflation over the coming year. The equation for the AS
curve is:
CHAPTER 12 Stabilization Policy and the AS/AD Framework
 In the basic AS/AD framework, we assume expected
inflation adjusts slowly, or is sticky. In other words,
we have adaptive expectations, so that
.
 The AS/AD framework is quite intuitive. In a single
graph, it allows us to study shocks to the economy as
inflation shocks, aggregate demand shocks, and
changes in the inflation target. The graph shows how
inflation and short-run output evolve over time. In
general, the principle of transition dynamics applies,
and the economy moves gradually back to its steady
state after a shock. These dynamics are driven by the
slow adjustment of expected inflation and show up as
shifts in the AS curve.
CHAPTER 12 Stabilization Policy and the AS/AD Framework
 Modern monetary policy recognizes that managing
inflation expectations is an important key to
stabilizing the economy. The theory of rational
expectations says that in order to determine future
inflation, people analyze all information that is
available to them. Systematic monetary policy,
reputation, and inflation targets are tools that central
banks use to help them manage inflation
expectations. By anchoring inflation expectations,
central banks can achieve low inflation and stable
output in the least costly fashion.
CHAPTER 12 Stabilization Policy and the AS/AD Framework
CHAPTER 12 Stabilization Policy and the AS/AD Framework