chap021 - Chapter 21 Output, Inflation and Monetary Policy...

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Chapter 21 Output, Inflation and Monetary Policy Chapter Overview Everyone is preoccupied with monetary policy, from traders to consumers to politicians. The objective of this chapter is to understand fluctuations in inflation and real output and how central banks use interest rate policy to stabilize them. To accomplish this, we will develop a macroeconomics model of fluctuations in the business cycle in which monetary policy plays a central role. The model is developed in three steps: (1) long-run equilibrium is described (2) the dynamic aggregate demand curve is derived and (3) aggregate supply is introduced. As we move through chapter, keep in mind that our ultimate objective is to understand how modern central bankers set interest rates, what they are reacting to when they change the target, and the impact on the economy. Reading this chapter will prepare students to: understand the development of the dynamic aggregate demand curve and the importance of the central bank’s actions in the formulation of that construct; describe aggregate supply in both the short run and the long run; and use the model that combines dynamic aggregate demand and aggregate supply to explain fluctuations in economic activity. Important Points of the Chapter To understand monetary policy we need to develop a macroeconomic model of fluctuations in the business cycle in which monetary policy plays a central role. Short- run movements in inflation and output can arise from changes in aggregate demand and changes in aggregate supply. Modern monetary policymakers work to eliminate the volatility that such changes cause by adjusting the target interest rate, which influences the components of aggregate demand. Application of Core Principles Principle #5: Stability (page 509) In the short run, output can be above or below its potential. Principle #4: Time (page 514) An investment can be profitable only if its internal rate of return exceeds the cost of borrowing, so the higher the real interest rate, the lower the level of investment. Principle #5: Stability (page 519) The relationship between the real interest rate and aggregate demand helps central bankers stabilize current output at a level close to potential output; they adjust the rate to close any output gap. Instructor’s Manual t/a Cecchetti: Money, Banking, and Financial Markets 44
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Chapter 21 Modern Monetary Policy and Aggregate Demand Principle #5: Stability (page 523) Central bankers envision themselves as reacting to changes in the economic environment. They change nominal interest rates in order to bring about changes in real interest rates that will affect the economic decisions of firms and households and so return the economy to the desired level. Principle #4: Time (page 528)
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This note was uploaded on 02/12/2012 for the course ECON 101 taught by Professor Abrams during the Spring '11 term at Adams State University.

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chap021 - Chapter 21 Output, Inflation and Monetary Policy...

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