LEARNING OBJECTIVES
After you have read this section, you should be able to answer the following questions:
How do prices adjust in the economy?
What are the effects of monetary policy on prices and inflation?
What is the Taylor rule?
We now understand the effect of an interest rate increase on output. According to the monetary transmission mechanism, we expect that this will result in lower spending and a lower real gross domestic product (GDP). Remember, though, that the Fed is also charged with worrying about prices and inflation. Look back at the Federal Open Market Committee (FOMC) announcement with which we opened the chapter. Much of that announcement concerns inflation, not output. It states that “inflation and longer-term inflation expectations remain well contained,” that “underlying inflation [is] expected to be relatively low,” and that “the Committee will respond to changes in economic prospects as needed to fulfill its obligation to maintain price stability.” [***Federal Open Market Committee, “Press Release,” Federal Reserve, February 2, 2005, accessed July 20, 2011,http://www.federalreserve.gov/boarddocs/press/monetary/2005/20050202/default.ht ****]
The statements by the Bank of England, the Central Bank of Egypt, and the Reserve Bank of Australia likewise betray a strong concern with inflation. The policy of many central banks is directed toward the inflation rate. This policy, appropriately called inflation targeting, focuses the attention of the monetary authority squarely on forecasting inflation and then controlling inflation through its current policy choices.
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