Macroeconomics

Taylor principle,

after economist John Taylor, who emphasized its impor-

tance in the design of monetary policy. Most of our analysis in this chapter

assumed that the Taylor principle holds (that is, we assumed that 

v

p

> 0). 

We can see now that there is good reason for a central bank to adhere to 

this guideline.

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F I G U R E

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Inflation, 

p

p

p

t

p

t + 2

p

t + 1

p

t – 1

Income, output, Y

DAS

t + 2

DAS

t + 1

Y

t

Y

t + 1

Y

t + 2

Y

t – 1

Y

all

A

C

D

B

DAS

t – 1, t 

DAD

t – 1,  t + 1…

DAD

t

Spiralling

inflation

The Importance of the Taylor Principle

This figure shows the impact 

of a demand shock in an economy that does not satisfy the Taylor 

principle, so the dynamic aggregate demand curve is upward sloping. 

A demand shock moves the DAD curve to the right for one period, to

DAD

t

, and the economy moves from point A to point B. Both output and

inflation increase. The rise in inflation increases expected inflation and, in

the next period, shifts the dynamic aggregate supply curve upward to

DAS

t

+1

. Therefore, in period t

+ 1, the economy then moves from point B

to point C. Because the DAD curve is upward sloping, output is still above

the natural level, so inflation continues to increase. In period t

+ 2, the

economy moves to point D, where output and inflation are even higher.

Inflation spirals out of control.

What Caused the Great Inflation?

In the 1970s, inflation in the United States got out of hand. As we saw in previ-

ous chapters, the inflation rate during this decade reached double-digit levels.

Rising prices were widely considered the major economic problem of the time.

In 1979, Paul Volcker, the recently appointed chairman of the Federal Reserve,

CASE STUDY

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announced a change in monetary policy that eventually brought inflation back

under control. Volcker and his successor, Alan Greenspan, then presided over low

and stable inflation for the next quarter century.

The dynamic AD –AS model offers a new perspective on these events.

According to research by monetary economists Richard Clarida, Jordi Gali,

and Mark Gertler, the key is the Taylor principle. Clarida and colleagues

examined the data on interest rates, output, and inflation and estimated the

parameters of the monetary policy rule. They found that the Volcker–Greenspan

monetary policy obeyed the Taylor principle, whereas earlier monetary poli-

cy did not. In particular, the parameter 

v

p

was estimated to be 0.72 during the

Volcker–Greenspan regime after 1979, close to Taylor’s proposed value of 0.5,

but it was 

−0.14 during the pre-Volcker era from 1960 to 1978.

2

The nega-

tive value of 

v

p

during the pre-Volcker era means that monetary policy did

not satisfy the Taylor principle.

This finding suggests a potential cause of the great inflation of the 1970s.

When the U.S. economy was hit by demand shocks (such as government

spending on the Vietnam War) and supply shocks (such as the OPEC 

oil-price increases), the Fed raised nominal interest rates in response to ris-

ing inflation but not by enough. Therefore, despite the increase in nominal

interest rates, real interest rates fell. The insufficient monetary response not

only failed to squash the inflationary pressures but actually exacerbated them.

The problem of spiraling inflation was not solved until the monetary-policy

rule was changed to include a more vigorous response of interest rates 

to inflation.

An open question is why policymakers were so passive in the earlier era. Here

are some conjectures from Clarida, Gali, and Gertler:

Why is it that during the pre-1979 period the Federal Reserve followed a rule that

was clearly inferior? Another way to look at the issue is to ask why it is that the

Fed maintained persistently low short-term real rates in the face of high or rising

inflation. One possibility . . . is that the Fed thought the natural rate of unemploy-

ment at this time was much lower than it really was (or equivalently, that the out-

put gap was much smaller). . . .

Another somewhat related possibility is that, at that time, neither the Fed nor

the economics profession understood the dynamics of inflation very well. Indeed,

it was not until the mid-to-late 1970s that intermediate textbooks began empha-

sizing the absence of a long-run trade-off between inflation and output. The

ideas that expectations may matter in generating inflation and that credibility is

important in policymaking were simply not well established during that era.

What all this suggests is that in understanding historical economic behavior, it is

important to take into account the state of policymakers’ knowledge of the econ-

omy and how it may have evolved over time. 

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P A R T   I V

Business Cycle Theory: The Economy in the Short Run

2

These estimates are derived from Table VI of Richard Clarida, Jordi Gali, and Mark Gertler,

“Monetary Policy Rules and Macroeconomic Stability: Evidence and Some Theory,” Quarterly

Journal of Economics 115, number 1 (February 2000): 147–180.

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