week 7

• it is assumed that when output is above its natural level, inflation increases; and when output is at its natural rate, inflation is constant
• the central banks choice of real interest rate depends on output and inflation; when inflation rises, real interest rates rise
• real interest rate is a function of output and inflation r = f( pi, Y)
• in the short term, the inflation adjustment (IA) line is independent to Y, so is a horizontal line
• the AD- IA schedule gives the long term equilibrium of inflation and output
• the IA line does not change with output
• supply shocks are changes in the natural rate of output, Y bar
• supply shocks come from changes in the inputs that would be available if the economy was operating at its natural rate (labour force, natural unemployment)
• supply shocks come from changes in output for a given level of inputs (productivity)
• an inflation shock is a disturbance to the usual behaviour of inflation that shifts the inflation adjustment (IA) line
• an inflation shock may be an oil price shock
• inflation shocks may come from changes to wages, other labour costs, input costs or productivity, as all these things contribute to a firms pricing system
• credible central banks result in quicker adjustments to new inflation levels
• credibility of monetary policy has an important effect on the cost of reducing inflation
• with a credible central bank, announcing measures to manage inflation will result in changes to inflation before measures are introduced
• the lower bound of nominal interest rates is 0
• expected inflation is an increasing function of actual inflation; higher actual inflation results in higher expected inflation