Macroeconomics

1 4-4

Two Applications: Lessons 

for Monetary Policy

So far in this chapter, we have assembled a dynamic model of inflation and output

and used it to show how various shocks affect the time paths of output, inflation, and

interest rates. We now use the model to shed light on the design of monetary policy.

It is worth pausing at this point to consider what we mean by the phrase “the

design of monetary policy.” So far in this analysis, the central bank has had a sim-

ple role: it merely had to adjust the money supply to ensure that the nominal

interest rate hit the target level prescribed by the monetary-policy rule. The two

key parameters of that policy rule are 

v

p

(the responsiveness of the target inter-

est rate to inflation) and 

v

Y

(the responsiveness of the target interest rate to out-

put). We have taken these parameters as given without discussing how they are

chosen. Now that we know how the model works, we can consider a deeper

question: what should the parameters of the monetary policy rule be?

The Tradeoff Between Output Variability 

and Inflation Variability

Consider the impact of a supply shock on output and inflation. According to the

dynamic AD –AS model, the impact of this shock depends crucially on the slope

of the dynamic aggregate demand curve. In particular, the slope of the DAD

curve determines whether a supply shock has a large or small impact on output

and inflation.

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P A R T   I V

Business Cycle Theory: The Economy in the Short Run

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This phenomenon is illustrated in Figure 14-12. In the two panels of this fig-

ure, the economy experiences the same supply shock. In panel (a), the dynamic

aggregate demand curve is nearly flat, so the shock has a small effect on inflation

but a large effect on output. In panel (b), the dynamic aggregate demand curve

is steep, so the shock has a large effect on inflation but a small effect on output.

Why is this important for monetary policy? Because the central bank can

influence the slope of the dynamic aggregate demand curve. Recall the equation

for the DAD curve:

Y

t

= Y−

t

− [

av

p

/(1 + 

av

Y

)](

p

t

−

p

t

*) + [1/(1 + 

av

Y

)]

e

t

.

C H A P T E R   1 4

A Dynamic Model of Aggregate Demand and Aggregate Supply

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