Suppose contracts are signed at the beginning of the period with the

Suppose contracts are signed at the beginning of the

This preview shows page 7 - 9 out of 32 pages.

Suppose contracts are signed at the beginning of the period with the expectation that aggregate demand will be at AD 0 in Figure 10.6 o There is then an unexpected increase in aggregate demand to AD 1 that takes place in the first half of the period o The equilibrium in the first half of the period, in which no contract can be revised will then shift to point B o In the middle of the period, half the firms and workers will negotiate their contracts; but they increase their wages by a relatively small amount The workers and firms that are involved in the negotiations worry about their competitive position relative to other firms and workers The AS curve shifts up by a relatively small amount, to AS 1 , and the equilibrium in the second half of the period is at point C o Overtime, the AS curve shifts up very gradually until it reaches AS F Policy Implications: o If labour contracts do not overlap, then the predictions of the model are very similar to those of the misperceptions model o If labour contracts overlap, then there is a great deal of inertia in the nominal wages. In that case:
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There are persistent deviations of output from full employment Policy intervention is very effective 10.3 DETERMINATION OF OUTPUT AND INFLATION RATE Most of the time in macroeconomics, we are not so much interested in the determination of the price level as in the determination of the inflation rate Now we will study how the aggregate demand and aggregate supply relations that we have derived could be extended to study the determination of the inflation rate We will use the Taylor Rule in order to recast the aggregate demand curve as a curve that gives for each inflation rate the output that will be demanded We will then recast the aggregate supply curve Monetary Policy and Aggregate Demand Modern central banks alter the money supply in response to changes in the economy o When the inflation rate and output rise, the central bank tends to reduce the money supply to reduce aggregate demand and cool off the economy o When the inflation rate and output fall, the central back tends to increase the money supply to increase aggregate demand and stimulate the economy The Taylor Rule is a simple model of how central banks act: o The central bank has target values of inflation ( π ' ) and output ( Y ¿ ) , and an estimate of what the normal real interest rate should be ( r ¿ ) o If inflation and output are higher than their target values, the central bank raises the real interest rate o If inflation and output are lower than their target values, the central bank lowers the real interest rate The Taylor Rule can be expressed in the equation form: } × left (π- {π} ^ {'} right ) +δ × (Y- {Y} ^ {*} ) r = r ¿ + ϕ ¿ Where: } and δ ϕ ¿ Determine how aggressively the central bank reacts to deviations of inflation and output from their targets With the Taylor Rule, the central bank is willing to supply as much money as is demanded at the interest rate given by the equation
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