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Unformatted text preview: tted in Figure 2B. (Alternatively, for
each possible interest rate i, the schedule shows the level of national income for
which investment equals savings, as this is equivalent to equality between supply
of and demand for funds.) The monetary policy reaction function of the central
bank, indicating how the central bank’s interest-rate target will vary with the level of
economic activity, is shown by the curve MP in this figure.3
If we suppose that the MP curve is drawn for a given inflation rate, then the
upward slope shown indicates a response of interest rates to the level of output (relative
tive to trend or to potential), of a kind implied, for example, by the “Taylor rule”
(Taylor, 1993)—that is, higher interest rates when output is high relative to trend or
potential, and lower interest rates when output is low relative to trend or potential.
In this case, the equilibrium level of output determined in Figure 2B depends on
the inflation rate; a graph showing how the equilibrium level of output would vary
with inflation yields an aggregate demand rela...
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