6 Businesses set prices and workers negotiate for wages based on what they

6 businesses set prices and workers negotiate for

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real interest rate equal to the marginal product of capital. 6. Businesses set prices (and workers negotiate for wages) based on what they think average inflation will be in the future. If they believe inflation will be high, they demand higher prices, and so the inflation expectations become self-fulfi lling. If the Fed can convince businesses that it will not tolerate infl ation, then businesses know that their competitors are Illustrating the Taylor principle with a few numerical examples is the best way to make the point. If the nominal rate is currently 4 percent with 2 percent inflation, and then the Federal reserve gets news that inflation will soon rise by 1 percent, what must the Fed do? The Taylor principle says the Fed must raise the nominal rate by more than 1 percent. Let’s say it raises the rate from 4 percent to 5.5 percent. That’s a big rate hike! Voters will complain; the central bank will be unpopular. Nobody is happy—and all because the Fed believes that inflation will rise otherwise. Let’s look at what happens if the central bank chooses to ignore the Taylor principle—let’s say that when news of higher inflation rises, the central bank decides to be “tough” but not “brutal.” So, when news arrives that infl ation is head- ing up to 3 percent, it raises the fed funds rate to 4. Five percent—that sounds tough, right? But let’s compare the real cost of borrowing before and after in these two cases: Taylor principle “Tough, not brutal” Real before 4% 2% = 2% 4% 2% = 2% Real after 5.5% 3% = 2.5% 4.5% 3% = 1.5% Notice what happened in the two cases: under the Taylor principle, when inflation rises the Fed raises the nominal interest enough to raise the real interest rate—thus cooling off the economy. Under the “tough, not brutal” policy, when inflation rises, the Fed raises the nominal rate—so it “feels tough”—but it ends up cutting the real rate! It has just made the boom even bigger! This will increase infl ation even more, according to the Phillips curve. (Note: If you really want to make the point painfully clear, you can show that the “tough, not brutal” rule implies an AD curve with a positive slope. It’s just a slightly negative slope on the policy rule’s parameter. Under such a rule, if you start from the steady state, any positive price shock leads to explosive inflation—which may just be what happened in the 1970s.) REVIEW QUESTIONS 1. Thinking of policy in terms of a rule is helpful because it helps the private sector to form accurate expectations about the future. If the central bank can reduce uncertainty by fol- lowing a rule, then private businesses and workers will be better able to plan for the future, which may improve eco- nomic stability. Also, following a rule is good for helping policy makers to think clearly. When you use a rule, you can run economic simulations where you compare your favorite rule against other policy rules. That way, you can find out which rule is best. Rules are easy to compare to one another, while discre- tion is hard to compare to anything.

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