Interest rate ( r )
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Interest rate (r ) Inflation rate (π) Fed Reaction Rule If the Fed sees the inflation rate rising… …it moves to raise interest rates r 0 r 1 π 1 π 0 B A
description
B. A. Fed Reaction Rule. If the Fed sees the inflation rate rising…. Inflation rate ( π ). π 1. π 0. …it moves to raise interest rates. r 0. r 1. Interest rate ( r ). A. B. 45. AD 0 (with old interest rate, r 0 ). E 0. AD 1 (with new, higher interest rate, r 1 ). - PowerPoint PPT Presentation
Transcript of Interest rate ( r )
Interest rate (r )
Infla
tion
rate
(π
)
Fed Reaction Rule
If the Fed sees the inflation rate rising…
…it moves to raise interest rates
r0 r1
π1
π0
B
A
45
Income
Agg
rega
te D
eman
d an
d O
utpu
t
AD1 (with new, higher
interest rate, r1)E1
E0
AD0 (with old
interest rate, r0)
Y1 Y0
A
B
Fed sees inflation rising
Raises interest rates
Investment is discouraged
Aggregate demand falls
Equilibrium GDP falls
Output (Y )
Infla
tion
rate
(π
)
Aggregate Demand Equilibrium (ADE)
If inflation rises…
…the Fed takes action to “cool off” the economy
Y1
π1
π0
Y0
A
B
Fed sees inflation falling
Lowers interest rates
Investment is encouraged
Aggregate demand rises
Equilibrium GDP rises
Output (Y )
Infla
tion
rate
(π
)
ADE0
ADE1
Output (Y )
Infla
tion
rate
(π
)
ADE1
ADE05% target
10% target
Output (Y )
Infla
tion
rate
(π
) Aggregate Supply Response (ASR)
Maximum Capacity
Y*
Recession
Wage-Price Spiral
Output (Y )
Infla
tion
rate
(π
)
ASR0
ASR1
Output (Y )
Infla
tion
rate
(π
)
ASR1
ASR0
Expansion of Maximum Capacity
Output (Y )
Infla
tion
rate
(π
) ASR
Y*
Recession
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Unemployment Rate (percent)
Infla
tion
(per
cent
per
yea
r)
Output (Y )
Infla
tion
rate
(π
) ASR
Y*
ADE1
ADE0
E1
E0
Recession
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0 1 2 3 4 5 6 7 8
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Unemployment Rate (percent)
Infla
tion
(per
cent
per
yea
r)
Output (Y )
Infla
tion
rate
(π
) ASR
Y*
ADE1
ADE0
E1
E0
Wage-Price Spiral
0
1
2
3
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5
6
0 1 2 3 4 5 6 7 8
1963
19691968
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19651964
Unemployment Rate (percent)
Infla
tion
(per
cent
per
yea
r) 1970 1971
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Output (Y )
Infla
tion
rate
(π
)
ASR0
Y*
ADE0
ADE1
E0
E1ASR1
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Unemployment Rate (percent)
Infla
tion
(per
cent
per
yea
r)
Output (Y )
Infla
tion
rate
(π
)
ASR0
ASR1
ADE
E1
E0
Lower Capacity
Output (Y )
Infla
tion
rate
(π
)
ASR0
ASR1
ADE
E1
E0
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Unemployment Rate (percent)
Infla
tion
(per
cent
per
yea
r)
Output (Y )
Infla
tion
rate
(π
) ASR
Y*
Recession
ADE0
ADE1
E0E1
Output (Y )
Infla
tion
rate
(π
)
ASR0
Y*
Recession
ADE0
E0
E1ASR1
ADE1
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0 1 2 3 4 5 6 7 8 9 10
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Unemployment Rate (Percent)
Infla
tion
(Per
cent
Per
Yea
r)
0
0.5
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1.5
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3
3.5
4
0 1 2 3 4 5 6 7 8 9 10
1992
1998
1999
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1997
Unemployment Rate (percent)
Infla
tion
(per
cent
per
yea
r)
Output (Y )
Infla
tion
rate
(π
)
ASR1
ASR0
ASR2
ADE
E0
E2
E1
Higher Capacity
Output (Y )
Infla
tion
rate
(π
) Classical ASR
Y*
ADE
Year
Peak Peak
Trough
GD
P
Y*
A A
B
Output (Y )
Infla
tion
rate
(π
)
ASR
Y*
ADE
ADE
A
B
Output (Y )
Infla
tion
rate
(π
)
Y*
ADE1
ADE0
E1
E0
Classical ASR
ASR1
ASR0
