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## Key Concepts

- Monetary policy often follows a systematic approach that can be characterized as a monetary policy rule. In the simple rule explored in this chapter, , the central bank increases the real interest rate whenever inflation exceeds a particular target. Although it's difficult to imagine such a simple rule reflecting the real world, it turns out to describe monetary policy in the U.S. economy over the last few decades reasonably well.
- Combining a monetary policy rule with the IS curve leads to an aggregate demand (AD) curve, which describes how the central bank chooses the level of short-run output based on the current rate of inflation.
- The aggregate supply (AS) curve, another name for the Phillips curve, tells us that the current rate of inflation depends positively on short-run output. A booming economy leads firms to raise their prices by more than last period's rate of inflation, leading to an even higher rate of inflation over the coming year. The equation for the AS curve is .
- In the basic AS/AD framework, we assume expected inflation adjusts slowly, or is sticky. In other words, we have adaptive expectations, so that .
- The AS/AD framework is quite intuitive. In a single graph, it allows us to study shocks to the economy as inflation shocks, aggregate demand shocks, and changes in the inflation target. The graph shows how inflation and short-run output evolve over time. In general, the principle of transition dynamics applies, and the economy moves gradually back to its steady state after a shock. These dynamics are driven by the slow adjustment of expected inflation and show up as shifts in the AS curve.
- Modern monetary policy recognizes that managing inflation expectations is an important key to stabilizing the economy. The theory of rational expectations says that in order to determine future inflation, people analyze all information that is available to them. Systematic monetary policy, reputation, and inflation targets are tools that central banks use to help them manage inflation expectations. By anchoring inflation expectations, central banks can achieve low inflation and stable output in the least costly fashion.

## 12.1 Introduction

## 12.2 Monetary Policy Rules and Aggregate Demand

- The AD Curve
- Moving along the AD Curve
- Shifts of the AD Curve

## 12.3 The Aggregate Supply Curve

## 12.4 The AS/AD Framework

- The Steady State
- The AS/AD Graph

## 12.5 Macroeconomic Events in the AS/AD Framework

- Event #1: An Inflation Shock
- Case Study: Oil Prices and Inflation Shocks
- Event #2: Disinflation
- Event #3: A Positive AD Shock
- Further Thoughts on Aggregate Demand Shocks
- Case Study: Real Business Cycle Models and the "New Economy"

## 12.6 Empirical Evidence

- Predicting the Fed Funds Rate
- Inflation-Output Loops
- Case Study: Forecasting and the Business Cycle

## 12.7 Modern Monetary Policy

- More Sophisticated Monetary Policy Rules
- Rules versus Discretion
- The Paradox of Policy and Rational Expectations
- Managing Expectations in the AS/AD Model
- Case Study: Rational Expectations and the Lucas Critique
- Inflation Targeting
- Case Study: Choosing a Good Federal Reserve Chair
- Conclusion

## 12.8 Additional Resources

- Summary
- Key Concepts
- Review Questions
- Exercises
- Worked Exercises