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We argued in Chapter 10 that monetary policy makers must adhere to the Taylor prin-ciple in order for the inflation rate to be stable. We can use the aggregate demand and supply model to formally demonstrate this result by showing that if policy makers do not follow the Taylor principle, inflation will be unstable.

A central bank that does not follow the Taylor principle will fail to raise nominal interest rates more than the increase in expected inflation. As a result, higher inflation will lead to a decline in real interest rates, as shown by the downward-sloping MP curve in panel (a) of Figure 12A1.1. As the real interest rate falls and we move from point A to point 1 to point B on the MP curve, equilibrium output rises from point A to point 1 to point B on the IS curve in panel (b) and the AD curve in panel (c), with the result that the AD curve is upward sloping.

Referring to panel (c), suppose that the economy starts at point 1, at the intersec-tion of the AD curve with the long-run aggregate supply curve LRAS and the short-run aggregate supply curve AS1. Now suppose that a negative supply shock that raises prices causes the short-run aggregate supply curve to shift up to AS2. The economy moves to point 2, where aggregate output has risen to Y2 and inflation has risen to π2. Expected inflation now rises, and so the short-run aggregate supply curve shifts up to AS3 and the economy moves to point 3, where aggregate output at Y3 is further above potential output. This causes the short-run aggregate supply curve to rise further, sending the economy to point 4, with an even larger increase in output and inflation to Y4 and π4. In other words, as inflation rises from π1 to π2 to π3 to π4, the downward sloping MP curve indicates that the real interest rate is falling, which leads to higher planned expenditure and thus a rise in aggregate output from Y1 to Y2 to Y3 to Y4. The result is then an ever-accelerating inflation rate, which keeps on rising faster and faster, shooting off into the stratosphere.

The same reasoning indicates that if there is a negative price shock, inflation will just keep on falling, with accelerating deflation setting in.

The Taylor Principle and Inflation Stability

Chapter 12 Appendix A

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2     chapter 12 appendix a

Figure 12A1.1

Not Following the Taylor Principle Leads to unstable inflationNot following the Taylor principle leads to a downward-sloping MP curve in panel (a). As inflation rises and we move from point A to point 1 to point B on the MP curve, the equi-librium output rises at points A, 1, and B on the IS curve in panel (b) and the AD curve in panel (c). The AD curve is therefore upward sloping. A positive price shock shifts the short-run aggregate supply curve up to AS2, with the result that the economy moves to point 2. Expected inflation now rises and the short-run aggregate supply curve shifts up further to AS3, and the economy moves to point 3. The short-run aggre-gate supply curve shifts up even further to AS4, and inflation keeps on rising at an accelerating pace, and so inflation is highly unstable.

Inflation Rate, p

RealInterestRate, r

(a) MP Curve

p1

r1

rB

rA

1

MP

(b) IS Curve

Aggregate Output, Y

(c) AD/AS Diagram

Aggregate Output, Y

InflationRate, p

Step 3. Expected inflation rises,shifting AS further upward…

RealInterestRate, r

Step 4. leading toa spiraling increasein inflation.

Step 1. ASshifts upward…

pA pB

A

B

Y1

r1

rB

rA

p1

pBp2

p3

pA

1

IS

YA YB

YP = Y1YA Y2 Y3 Y4YB

A

B

1

B

A

AD

2

4

3

AS1

AS2

AS3

AS4p4

LRAS

Step 2. leadingto an increasein output andinflation.

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Summary 1. Aggregate demand and supply analysis shows

that if policy makers do not follow the Taylor principle, inflation will be highly unstable. Following the Taylor principle is therefore a necessary condition for stable inflation.

revIew QueSTIonS and ProblemS

  Period 1

Period 2

Period 3

Period 4

Period 5

Nominal interest rate

10 10 10 10 10

Inflation rate

3 4 5 6 7

a) Plot the real interest rate (vertical axis) and the inflation rate (horizontal axis) for each period.

b) What does this monetary policy curve imply about the slope of the aggregate demand curve and inflation stability?

2. During the 1960s, interest rates changed on a one-to-one basis with inflation rates (i.e., a change in inflation was matched by the same change in nominal interest rates) in the United States.

a) What is the implication of a one-to-one change between nominal interest rates and inflation for the slope of the monetary policy curve?

b) As inflation picked up in the early 1960s, how do you think policy makers (or Fed officials) should have responded in order to fight inflation? (Hint: should they have followed the same monetary policy rule?)

1. Use the information in the following table to calculate the real interest rate for each period. (Hint: use the Fisher Equation.)

the taylor principle and inflation Stability     3     

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