Expected_Inflation -...

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Expected Inflation and the IS Curve:  The Wedge Approach When expected inflation is not zero there is a difference between the nominal and real  interest rate:  i = r +  π e .  Notice that expected inflation puts a “wedge” between nominal  and real interest rates in much the same way that sales taxes and subsidies put a wedge  between the price the consumer pays, P C , and the price the firm receives, P F .  P C  = P F sales tax; P C  = P F - subsidy.  I think a convenient way to analyze expected inflation and  changes in expected inflation is to use the wedge approach similar to the analysis of  Figures 6-8 and 6-9 in Mankiw’s principles text.  The trick is to realize that the vertical  axis measures both the nominal and real interest rates;  the nominal interest rate is  determined by the central bank, but the real interest rate is what matters for the IS curve.  Equilibrium occurs at the one value of Y, at which the nominal and real interest rates  differ by the expected rate of inflation (i-r =  π e ).  The graphs below show a short-run  equilibrium in an economy with positive expected inflation on the left and negative 
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This note was uploaded on 03/02/2010 for the course ECON 57 taught by Professor Woglom during the Spring '08 term at UMass (Amherst).

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Expected_Inflation -...

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