Inflation and Monetary Policy by alicejenny


									                  CHAPTER 28 - INFLATION AND MONETARY POLICY



       The tax hike is a negative spending shock, which would shift the AD curve to the left. If the
       Fed left the money supply unchanged, the economy would slide down the AS curve from point
       E to point F (see graph on the right). Both output and the price level would fall. If the Fed
       decides to use monetary policy to neutralize the spending shock, it would have to increase the
       money supply. This would lead to a lower interest rate (at point C, in the graph on the left),
       which would stimulate consumption and investment spending by enough to offset the initial
       spending shock. The economy would return to point E (in the graph on the right).

 4. Possibly, the announcement of the new dovish Chair itself would be enough to change the
    behavior of workers and firms. Understanding that the new Chair would fight unemployment
    even at the cost of inflation, they would expect higher inflation in the future. People would build
    higher inflation into their contracts and the Phillips curve would shift upward. At each level of
    unemployment, there would be a higher inflation rate. If the announcement were not enough to
    change expectations, but the Chair did, in fact, turn out to be more concerned with
    unemployment than inflation, the aggregate demand curve would begin shifting rightward more
    rapidly. The economy would ride up the Phillips curve in the short run, and once a higher
    inflation rate were built in to contracts, the Phillips curve itself would shift upward.
                                                 Chapter 28 Inflation and Monetary Policy


      The Fed would have to increase the money supply more rapidly in each successive year. This
      year, for example, it could increase the money supply by enough to hit the unemployment
      rate-inflation rate combination of U2 and 9%. But, as the Phillips curve shifts rightward to
      PCbuilt-in inflation = 9%, the Fed would have to increase the money supply even more next year, in
      order to move the economy to point K. But this, in turn, would make the Phillips curve shift
      rightward again. The inflation rate would rise continuously.


      Assume the economy is initially in equilibrium at point E. If the Fed wrongly believes that the
      natural rate of unemployment is higher and acts to bring the economy back to its supposed
      potential, it will decrease the money supply. This will cause the interest rate to rise from r1 to
      r2, causing the AD curve to shift leftward from AD1 to AD2. The economy will experience a
      lower price level and higher unemployment (at point F). With no more intervention, wage
      rates will eventually fall, causing the AS curve to shift rightward from AS1 to AS2, returning the
      economy to full employment (at point G). If the Fed, however, continues to decrease the
      money supply in an effort to maintain output below potential, the public will come to expect
      deflation in the future, and the economy will experience ongoing deflation.

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