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Unformatted text preview: tion in inflation–output space. Plotting
ting that relation along with a Phillips curve (or aggregate supply) relation between
inflation and output, one can then finally determine equilibrium output.4
This kind of model provides a straightforward account of the way in which a
central bank’s interest-rate policy affects the level of economic activity (and also the
inflation rate, once one adjoins a Phillips curve to the model). However, this model
of the credit market—in which ultimate savers lend directly to ultimate borrowers so
that the interest rate received by savers is the same as that paid by borrowers—clearly
omits some important features of actual financial systems. In actual economies, we
observe multiple interest rates that do not move perfectly together. Changes in
spreads between certain of these interest rates have been important indicators of
changing financial conditions, both during the recent housing boom and during
the subsequent crash, as is discussed further below.
3 In the case that monetary policy is assumed to correspond to some fixed supply of money, then the
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