Interest rate (r ) Inflation rate (π) Fed Reaction Rule If the Fed sees the inflation rate...
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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
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Transcript of Interest rate (r ) Inflation rate (π) Fed Reaction Rule If the Fed sees the inflation rate...
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
ADEE0
0
1
2
3
4
5
6
0 1 2 3 4 5 6 7 8
1963
19651964
Unemployment Rate (percent)
Infla
tion
(per
cent
per
yea
r)
Output (Y )
Infla
tion
rate
(π
) ASR
Y*
ADE1
ADE0
E1
E0
Recession
0
1
2
3
4
5
6
0 1 2 3 4 5 6 7 8
1963
19691968
1967
1966
19651964
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
4
5
6
0 1 2 3 4 5 6 7 8
1963
19691968
1967
1966
19651964
Unemployment Rate (percent)
Infla
tion
(per
cent
per
yea
r) 1970 1971
1972
1973
Output (Y )
Infla
tion
rate
(π
)
ASR0
Y*
ADE0
ADE1
E0
E1ASR1
0123456789
10
0 1 2 3 4 5 6 7 8 9 10
19701969
1975
1963
1973
1974
1976
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
0123456789
10
0 1 2 3 4 5 6 7 8 9 10
19701969
1975
1983
1963
1981
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
0123456789
10
0 1 2 3 4 5 6 7 8 9 10
2000
1998
1984
1992
1989
2007
Unemployment Rate (Percent)
Infla
tion
(Per
cent
Per
Yea
r)
0
0.5
1
1.5
2
2.5
3
3.5
4
0 1 2 3 4 5 6 7 8 9 10
1992
1998
1999
1994
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
