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

Figure 12.1 The Fed Reaction Rule

45

Income

Agg

rega

te D

em

and

and

Out

put

AD1 (with new, higher interest rate, r1)

E1

E0

AD0 (with old interest rate, r0)

Y1 Y0

A

B

Figure 12.2 Changing AD Equilibrium due to the Fed Reaction

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

Figure 12.3 The Aggregate Demand Equilibrium Curve

Output (Y)

Infla

tion

rate

(π

)

ADE0

ADE1

Figure 12.4 The Effect of Expansionary Fiscal Policy or Increased Confidence

Output (Y)

Infla

tion

rate

(π

)

ADE1

ADE05% target

10% target

Figure 12.5 The Effect of a Lower Target Inflation Rate

Output (Y)

Infla

tion

rate

(π

)

Aggregate Supply Response (ASR)

Maximum Capacity

Y*

Recession

Wage-Price Spiral

Figure 12.6 The Aggregate Supply Response (ASR) Curve

Output (Y)

Infla

tion

rate

(π

)ASR0

ASR1

Figure 12.7 An Increase in Inflationary Expectations

Output (Y)

Infla

tion

rate

(π

)

ASR1

ASR0

Expansion of Maximum Capacity

Figure 12.8 A Beneficial Supply Shock

Output (Y)

Infla

tion

rate

(π

)

ASR

Y*

Recession

ADEE0

Figure 12.9 An Economy in Recession

0

1

2

3

4

5

6

0 1 2 3 4 5 6 7 8

1963

19651964

Unemployment Rate (percent)

Infla

tion

(pe

rce

nt p

er

yea

r)

Figure 12.10 Unemployment and Inflation in the United States, 1963-1965

Output (Y)

Infla

tion

rate

(π

)

ASR

Y*

Recession

ADE0

ADE1E0

E1

Figure 12.11 Expansionary Fiscal Policy When the Economy Starts in a 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

pe

r ye

ar)

Figure 12.12 Unemployment and Inflation in the United States, 1963-1969

Output (Y)

Infla

tion

rate

(π

)ASR

Y*

ADE1

ADE0

E1

E0

Wage-Price Spiral

Figure 12.13 Expansionary Fiscal Policy When the Economy is at Full Employment

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

(pe

rce

nt p

er

yea

r)

1970 1971

1972

1973

Figure 12.14 Unemployment and Inflation in the United States, 1963-1973

Output (Y)

Infla

tion

rate

(π

)

ASR0

Y*

ADE0

ADE1

E0

E1ASR1

Figure 12.15 Contractionary Fiscal Policy and Rising Inflationary Expectations

0123456789

10

0 1 2 3 4 5 6 7 8 9 10

Infla

tion

(per

cent

per

yea

r)

Unemployment Rate (percent)

19701969

1975

1963

1973

1974

1976

Figure 12.16 Unemployment and Inflation in the United States, 1963-1976

Output (Y)

Infla

tion

rate

(π

)

ASR0

ASR1

ADE

E1

E0

Lower Capacity

Figure 12.17 The Immediate Effect of the Oil Price Shock

Output (Y)

Infla

tion

rate

(π

)

ASR0

ASR1

ADE

E1

E0

12.18 Medium-Run Adjustment to the Oil Price Shock

0123456789

10

0 1 2 3 4 5 6 7 8 9 10

Infla

tion

(pe

rce

nt p

er

yea

r)

Unemployment Rate (percent)

19701969

1975

1983

1963

1981

Figure 12.19 Unemployment and Inflation in the United States 1963-1983

Output (Y)

Infla

tion

rate

(π

)

ASR

Y*

Recession

ADE0

ADE1

E0E1

Figure 12.20 The Immediate Effect of a Lowered Inflation Target

Output (Y)

Infla

tion

rate

(π

)

ASR0

Y*

Recession

ADE0

E0

E1ASR1

ADE1

Figure 12.21 The Medium-Run Effect of a Lowered Inflation Target

0123456789

10

0 1 2 3 4 5 6 7 8 9 10

Infla

tion

(pe

rce

nt p

er

yea

r)

Unemployment Rate (percent)

2000

1998

1984

1992

1989

Figure 12.22 Unemployment and Inflation in the United States, 1983-2004

0

0.5

1

1.5

2

2.5

3

3.5

4

0 1 2 3 4 5 6 7 8 9 10

Infla

tion

(pe

rce

nt p

er

yea

r)

Unemployment Rate (percent)

1992

1998

1999

1994

1997

Figure 12.23 Unemployment and Inflation in the United States, 1992-1999

Output (Y)

Infla

tion

rate

(π

)

ASR1

ASR0

ASR2

ADE

E0

E2

E1

Higher Capacity

Figure 12.24 The Effects of Technological Innovation

Output (Y)

Infla

tion

rate

(π

) Classical ASR

Y*

ADE

Figure 12.25 The Classical Aggregate Supply Curve

Year

Peak Peak

Trough

GDP

Y*

A A

B

Output (Y)

Infla

tion

rate

(π

)

ASR

Y*

ADE

ADE

A

B

(a) (b)

Figure 12.26 Business Cycles

Output (Y)

Infla

tion

rate

(π

)

Y*

ADE1

ADE0

E1

E0

Classical ASR

ASR1

ASR0

Figure 12.27 Expansionary Monetary Policy with Rational Expectations