Monetary Policy and Inflation

  • At any single point in time, inflation rate is given, and the central bank’s choice of the real interest rate depends on both output and inflation
    • Lower interest rates if output is low, raise interest rates if output is high
    • Lower interest rates if inflation is low, raise interest rates if inflation is high
    • We can write real interest rates as a function of output and inflation: r(Y, π)

Four Principles of Inflation

  1. At a point in time, the inflation rate is given
  2. When the output is above the potentital output, inflation rises
  3. When the output is below the potentital output, inflation falls
  4. When the output is equal to the potentital output, inflation remains the same

IS-MP-AD-IA model

  • Note that monetary policy cannot affect the level of output or real interest rate in the long run, but it can affect the level of inflation in the long run
    • Central banks can have a long-run inflation target but not a long-run output or employment target
  • Shocks to inflation can occur due to exogenous changes in any of the following:
    • Wages: Min wage, unions
    • Other labor costs: benefits, payroll taxes
    • Costs of other inputs: oil, machinery, etc.
    • Competition/Markups: More competition means higher prices which means more inflation