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Inflation rate (π)
If the Fed sees the
inflation rate
rising…
Fed Reaction
Rule
π1
A
π0
…it moves to raise
interest rates
B
r0
r1
Interest rate (r )
Aggregate Demand and Output
E0
AD0 (with old
A
interest rate, r0)
AD1 (with new, higher
interest rate, r1)
E1
B
45
Y1
Y0
Income
Fed sees
inflation rising
Raises
interest rates
Investment is
discouraged
Aggregate
demand falls
Equilibrium
GDP falls
Inflation rate (π )
…the Fed takes action to
“cool off” the economy
B
π1
A
If inflation
rises…
π0
Aggregate Demand
Equilibrium (ADE)
Y1
Y0
Output (Y )
Fed sees
inflation falling
Lowers
interest rates
Investment is
encouraged
Aggregate
demand rises
Equilibrium
GDP rises
Inflation rate (π )
ADE1
ADE0
Output (Y )
Inflation rate (π )
10%
target
5%
target
ADE0
ADE1
Output (Y )
Aggregate Supply
Response (ASR)
Inflation rate (π )
Recession
WagePrice
Spiral
Maximum
Capacity
Y*
Output (Y )
Inflation rate (π )
ASR1
ASR0
Output (Y )
Inflation rate (π )
ASR0
ASR1
Expansion of
Maximum
Capacity
Output (Y )
Inflation rate (π )
Recession
ASR
E0
ADE
Y*
Output (Y )
Inflation (percent per year)
6
5
4
3
2
1965
1964
1963
1
0
0
1
2
3
4
5
6
7
8
Unemployment Rate (percent)
Inflation rate (π )
Recession
ASR
E1
ADE1
E0
ADE0
Y*
Output (Y )
Inflation (percent per year)
6
5
1969
1968
4
1967
3
1966
2
1965
1964
1
1963
0
0
1
2
3
4
5
6
7
8
Unemployment Rate (percent)
Inflation rate (π )
WagePrice
Spiral
ASR
E1
E0
ADE1
ADE0
Y*
Output (Y )
Inflation (percent per year)
6
1973
5
1970
1969
1968
4
1971
1972
1967
3
1966
2
1965
1964
1
1963
0
0
1
2
3
4
5
6
7
8
Unemployment Rate (percent)
Inflation rate (π )
ASR1
E1
E0
ASR0
ADE0
ADE1
Y*
Output (Y )
Inflation (percent per year)
10
9
8
7
6
5
4
3
2
1
0
1975
1974
1973
1969
1976
1970
1963
0 1 2 3 4 5 6 7 8 9 10
Unemployment Rate (percent)
Inflation rate (π )
ASR1
ASR0
E1
E0
ADE
Output (Y )
Lower
Capacity
Inflation rate (π )
ASR0
E0
E1
ASR1
ADE
Output (Y )
Inflation (percent per year)
1981
10
9
8
7
6
5
4
3
2
1
0
1975
1969
1970
1983
1963
0 1 2 3 4 5 6 7 8 9 10
Unemployment Rate (percent)
Inflation rate (π )
Recession
ASR
E1
E0
ADE0
ADE1
Y*
Output (Y )
Inflation rate (π )
Recession
ASR0
ASR1
E0
E1
ADE0
ADE1
Y*
Output (Y )
Inflation (Percent Per Year)
10
9
8
7
6
5
4
3
2
1
0
1989
1984
2007
2000
1992
1998
0 1 2 3 4 5 6 7 8 9 10
Unemployment Rate (Percent)
Inflation (percent per year)
4
3.5
3
1992
2.5
2
1.5
1
1994
1999
1997
1998
0.5
0
0 1 2 3 4 5 6 7 8 9 10
Unemployment Rate (percent)
Inflation rate (π )
ASR0
ASR1
ASR2
E0
E1
E2
ADE
Higher
Capacity
Output (Y )
Inflation rate (π )
Classical ASR
ADE
Y*
Output (Y )
GDP
Peak
Peak
A
A
Y*
B
Trough
Year
Inflation rate (π )
ASR
A
B
ADE
ADE
Y*
Output (Y )
Inflation rate (π )
Classical
ASR
E1
ASR1
E0
ADE1
ADE0
ASR0
Y*
Output (Y )