Chapter 21 econ.docx - Chapter 21 the Monetary Policy and Aggregate Demand Curves Taylor Principle why the monetary policy curve has an upward slope The

# Chapter 21 econ.docx - Chapter 21 the Monetary Policy and...

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Chapter 21- the Monetary Policy and Aggregate Demand Curves Taylor Principle why the monetary policy curve has an upward slope The central bank attempts to raise the real interest rate when inflation rises Monetary policy is assumed to be guided by an inflation target, pi*. Since C+I+G+Xn falls with r rises, the central bank tries to raise r when inflation rises above pi* and lowers r when inflation falls below pi* Monetary Policy Curve In reality, central banks set a target for the nominal interest rate, i (r = i-pi) The Taylor Principle implies that the central bank takes current inflation into account in determining the target rate for i and raises i by more than 1% for each 1% rise in inflation. If the central bank changes the target nominal interest rate due to anything other than a change in inflation, it corresponds in a shift on MP curve o For example, if the central bank is given a lower target for the inflation

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Unformatted text preview: rate (pi*) the MP curve shifts up Aggregate Demand Curve on a traditional AD curve overall price level is on the vertical axis and aggregate output (Y) is on the horizontal axis with the slow downward because higher prices discourage private demand Mishkin’s AD curve has the inflation rate on the vertical axis and downward slope because higher inflation leads to tigher monetary policy It is common to treat monetary policy in a way comparable to the treatment of fiscal policy o Fiscal policy is modeled as fixed levels of G and T while monetary policy is modeled as a fixed value for M o This means for example that we are attempting to determine the effect of an increase in G taking into account the tighter monetary policy that the extra inflation will trigger rather than attempting to determine the effect of the increase in G for a given M...
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