The classical model of
macroeconomics assumes
wages and prices are
completely flexible.
Inflation is the growth rate of
the price of aggregate output.
With an inflation target, the
central bank adjusts interest
rates to try to keep inflation
close to the target inflation rate.
Under inflation targeting, the ii
Schedule shows that at higher
inflation rates the central bank
will wish to have higher real
interest rates.
The central bank sets the
nominal interest r not the real
interest rate i.
The macroeconomic demand
schedule MDS shows how
higher inflation induces lower
output because a central bank
raises interest rates.
The aggregate supply
schedule shows the output
that firms wish to supply at
each inflation rate.
At potential output all inputs
are fully employed. It is long-run
equilibrium output.
Money illusion exists if
people confuse nominal and
real variables.
In the classical model, the
aggregate supply schedule is
vertical at potential output.
Equilibrium output is
independent of inflation.
Monetary policy
accommodates a permanent
supply change by altering the
real interest rate (shift in the ii
schedule) to induce a similar
change in aggregate demand.
In the classical model with a
vertical AS schedule, a rise in
government spending crowds
out an equal amount of
private spending.
In the classical model, faster
nominal money growth is
accompanied by higher inflation
but leaves real output constant
at potential output.
The short-run supply curve
SAS shows how desired output
varies with inflation, for a given
inherited growth of nominal
wages.
A permanent supply shock
changes potential output. A
temporary supply shock shifts
the short-run aggregate supply
schedule but leaves potential
output unaltered.
Monetary policy
accommodates a temporary
supply shock when monetary
policy is altered to help stabilize
output. The consequence,
however, is higher inflation.
When all shocks are demand
shocks, stabilizing inflation also
stabilizes output, even in a
Keynesian model.
Flexible inflation targeting
commits a central bank to hit
inflation targets in the medium
run but gives it some discretion
about how quickly to hit its
inflation target.
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