Question

The main advantage of using the interest rate, rather than the money supply, as the policy instrument in the dynamic AD–AS model is that it is more realistic. Today, most central banks, including the Federal Reserve, set a short-term target for the nominal interest rate. Keep in mind, though, that hitting that target requires adjustments in the money supply. For this model, we do not need to specify the equilibrium condition for the money market, but we should remember that it is lurking in the background. When a central bank decides to change the interest rate, it is also committing itself to adjust the money supply accordingly.

First, when inflation heats up, the federal funds rate should rise. An increase in the interest rate will mean a smaller money supply and, eventually, lower investment, lower output, higher unemployment, and reduced inflation. Second, when real economic activity slows—as reflected in real GDP or unemployment—the federal funds rate should fall. A decrease in the interest rate will mean a larger money supply and, eventually, higher investment, higher output, and lower unemployment. These two guidelines are represented by the monetary-policy equation in the dynamic AD–AS model.

The Fed needs to go beyond these general guidelines, however, and decide exactly how much to respond to changes in inflation and real economic activity.

A Dynamic Model of Aggregate Demand and Aggregate Supply

In the AD/AS model developed, monetary policy is shown by a shift in the aggregate demand curve. In the Phillips curve model, a change in monetary policy is shown by a movement along the Phillips curve.

How does monetary policy show up in the dynamic AD/AS model? (Explain in detail where it appears and the form that its takes. What is the Fed’s target for monetary policy? What happens if the Fed changes its target? What happens if there is an adverse supply shock?)

What is the Taylor Principle and what does it tell us about the wisdom of the Fed targeting (as it has for years) a nominal interest rate (the federal funds rate)?

Answer 1

Instead of the traditional model, the dynamic model has inflation and real GDP growth rate on the axes in lieu of prices and output. Monetary policy is reflected in the AD curve in dynamic AD AS model. The AD curve is based on the equation of exchange

M + V = P + Y

Hence, AD curve represents the P-Y points consistent with a specified rate of spending growth. Change in monetary policy brings about a shift in AD. Fed's target is money supply, if there is an adverse supply shock, the AD curve will shift leftwards.

Taylor is a rule set out for the optimal monetary policy in an economy, targeting interest rate allows managing the growth of GDP without impacting prices much