I thought I knew this… Schweser says, “When changes in monetary policy are announced and credible, the central bank is able to reduce inflation without creating a recession or increasing the level of unemployment. Thus, aggregate demand increases (shifts to the right) by an amount that is less than originally expected by the market, the money wage rate rises at a rate consistent with the increase in aggregate demand, and the short-run supply curve decreases (shifts to the left). The end result is that inflation is decreased, the unemployment level is maintained, and a recession is avoided. All of this is achievable only because the policy change was credible and announced. Without these two attributes, the policy change may be successful in reducing inflation, but at a cost of a recession or increased unemployment.” IR-Interest rate; MS-Money Supply; AD-Aggregate Demand; WR-Money wage rate; SAS-Shortrun Aggregate Supply Let me see if I understand this… IRinc --> MSdec --> ADinc --> WRinc --> SASdec ==> PRICEdec. So AD inc toward right will move P0 – P1 (higher). SASdec toward left should move P1 to P2 higher. So I just see price spiralling upward (further inflating) although GDP could remain the same. How is the price level reduced from its original value P0?. OR How does the policy address inflation? Thanks so much for taking the time.
The key here is that inflation falls, not the nominal price level. Thus although the two curve shifts you’ve mentioned do take place and P0 does rise to P2, still on the LRAS, it’s less than the hypothetical mentioned above where “aggregate demand increases (shifts to the right) by an amount that is less than originally expected by the market”. Had the policy not been implemented, AD would have risen further and inflation would further have increased. Were the policy implemented but not credible, the government would have had to pull inflation down slowly by lowering inflationary expectations - causing a recession and thus moving to the right on the Philips curve (higher unemployment, lower imflation). A bit hard to explain without graphs!
Thanks HJAA… So are you saying that P0 - P1 - P2 is normal price gain. Absence of the policy would make it P0 - P1’ - P2’ an inflationary price gain where P1’ and P2’ are much higher than P1 and P2 respectively? So I should not expect the price P0 to remain where it is OR fall, BUT to increase at a much less rate than that w/o the policy. This makes sense unless my interpretation is wrong…