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20%20Macroeconomic%20Policy,%20Part%202

20%20Macroeconomic%20Policy,%20Part%202 - Agenda 1...

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1 20-1 Macroeconomic Policy and Aggregate Demand and Supply Analysis, Part 2 20-2 Agenda 1. Stabilizing Inflation and Economic Activity a. Temporary Supply Shocks 2. Issues in Stabilization Policy a. How Active Should Policy Be? b. The Taylor Rule 3. Inflation: A Monetary Phenomenon a. Causes of Inflationary Monetary Policy 20-3 A Temporary Aggregate Supply Shock After a temporary aggregate supply shock, a central bank monetary policy of stabilizing inflation also stabilizes economic output in the long-run. Thus, there is no trade-off between the dual objectives of stabilizing inflation and stabilizing economic activity in the long-run. 20-4 A Temporary SRAS Shock Suppose: The economy is initially in general equilibrium at the target inflation rate , and There is then a temporary negative aggregate supply shock , and The central bank responds with a policy to stabilize inflation at π T in the short-run .
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2 20-5 Policy Response to Stabilize Inflation Y π Y P AD 0 π 0 = π T LRAS 0 SRAS 0 ( π e = π 0 ) 20-6 Policy Response to Stabilize Inflation π r π 0 = π T r 0 = r* 0 MP 0 20-7 Policy Response to Stabilize Inflation The adjustment process: 1. A negative temporary aggregate supply shock will shift the SRAS curve to the left, increasing inflation, increasing the real interest rate along the MP curve, and reducing economic output. 20-8 Policy Response to Stabilize Inflation The adjustment process: 2. To stabilize inflation at its target rate, the central bank immediately responds with an autonomous tightening of monetary policy which shifts the MP and AD curves to the left, increasing the real interest rate, reducing economic output, and reducing inflation to π T .
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