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7.12 Keynesian Economics Without the LM Curve

The modern approach to stabilization policy outlined in section 7.11 above is

now reflected in the ideas taught to students of economics, even at the

principles level (see D. Romer, 2000; Taylor, 2000b, 2001). The following

simple model is consistent with the macroeconomic models that are currently

used in practice by the US Federal Reserve and the Bank of England (see

Bank of England, 1999; Taylor, 1999; Clarida et al., 2000). Following Taylor

(2000b), the model consists of three basic relationships. First, a negative

relationship between the real rate of interest and GDP of the following form:

y = −ar + μ (7.20)

where y measures real GDP relative to potential GDP, r is the real rate of

interest, μ is a shift term which, for example, captures the influence of

exogenous changes to exports and government expenditures and so on. A

higher real rate of interest depresses total demand in an economy by reducing

consumption and investment expenditures, and also net exports via exchange

rate appreciation in open economies with floating exchange rates. This relationship

is ‘analogous’ to the IS curve of conventional textbook IS–LM

analysis. The second key element in the model is a positive relationship

between inflation and the real rate of interest of the form:

r = bP˙ + v (7.21)

where ˙P is the rate of inflation and v is a shift term. This relationship, which

closely mirrors current practice at leading central banks, indicates that when

inflation rises the monetary authorities will act to raise the short-term nominal

interest rate sufficient to raise the real rate of interest. As Taylor (2000b)

and D. Romer (2000) both point out, central banks no longer target monetary

aggregates but follow a simple real interest rate rule. The third key relationship

underlying the modern monetary policy model is a ‘Phillips curve’ type

relationship between inflation and GDP of the form:

P˙ P˙ cy w = t−1 + t−1 + (7.22)

where w is a shift term. As equation (7.22) indicates, inflation will increase

with a lag when actual GDP is greater than potential GDP (y > y*) and vice

versa. The lag in the response of inflation to the deviation of actual GDP from

potential GDP reflects the staggered price-setting behaviour of firms with

market power inducing nominal stickiness. While this aspect indicates the

new Keynesian flavour of this model, the relationship also allows for expectations

of inflation to influence the actual rate.

From these three simple relationships we can construct a graphical illustration

of the modern approach to stabilization policy. Combining equations

(7.20) and (7.21) yields the following equation:

y = −abP˙ + μ − av (7.23)

Equation (7.23) indicates a negatively sloped relationship between inflation

and real GDP, which both Taylor and Romer call an aggregate demand

(AD) curve. Figure 7.15 illustrates the derivation of the aggregate demand

curve.

Figure 7.15 Derivation of the AD curve

(a)

Real

interest

rate

Output

MP1

MP0

r1

r0

IS

(b)

Inflation

Output

P ˙

1

P ˙

0

AD

For simplicity, if we assume that the central bank’s choice of real interest

rate depends entirely on its inflation objective, the monetary policy (MP) real

rate rule can be shown as a horizontal line in panel (a) of Figure 7.15, with

shifts of the MP curve determined by the central bank’s reaction to changes

in the rate of inflation. Equation (7.20) is represented by the IS curve in

Figure 7.15. In panel (b) of Figure 7.15 we see equation (7.23) illustrated by

a downward-sloping aggregate demand curve in inflation–output space. The

intuition here is that as inflation rises the central bank raises the real rate of

interest, thereby dampening total expenditure in the economy and causing

GDP to decline. Similarly, as inflation falls, the central bank will lower the

real rate of interest, thereby stimulating total expenditure in the economy and

raising GDP. We can think of this response as the central bank’s monetary

policy rule (Taylor, 2000b).

Shifts of the AD curve would result from exogenous shocks to the various

components to aggregate expenditure, for example the AD curve will shift to

the right in response to an increase in government expenditure, a decrease in

taxes, an increase in net exports, or an increase in consumer and/or business

confidence that leads to increased expenditures. The AD curve will also shift

in response to a change in monetary policy. For example, if the monetary

authorities decide that inflation is too high under the current monetary policy

rule, they will shift the rule, raise real interest rates and shift the AD curve to

the left (see Taylor, 2001).

The Phillips curve or inflation adjustment relationship, given by equation

(7.22), is represented by the horizontal line labelled IA0 in Figure 7.16. Following

Taylor (2000b) and D. Romer (2000), this can be thought of as the aggregate

supply component of the model, assuming first that the immediate impact of an

increase in aggregate demand will fall entirely on aggregate output, and second

that when actual GDP equals potential or ‘natural’ GDP (y = y*), inflation will

be steady, but when y > y*, inflation will increase and when y < y*, inflation will

decline. Both of these assumptions are consistent with the empirical evidence

and supported by new Keynesian theories of wage and price stickiness in the

short run (Gordon, 1990). When the economy is at its potential output the IA

line will also shift upwards in response to supply-side shocks such as a rise in

commodity prices and in response to shifts in inflationary expectations. Figure

7.16 illustrates the complete AD–IA model.

Long-run equilibrium in this model requires that AD intersect IA at the

natural rate of output (y*). Assume that the economy is initially in long-run

equilibrium at point ELR 0 and that an exogenous demand shock shifts the AD

curve from AD0 to AD1. The initial impact of this shift is an increase in GDP

from y* to y1, with inflation remaining at P˙0 . Since y1 > y*, over time the rate

of inflation will increase, shifting the IA curve upwards. The central bank will

respond to this increase in inflation by raising the real rate of interest, shown

Figure 7.16 Adjusting to long-run equilibrium in the AD-IA model

Output

Inflation

P ˙

1

P ˙

0

AD AD1 0

ELR1

ELR0 IA0

IA1

y* y1

by an upward shift of the MP curve in the IS–MP diagram (Figure 7.15). The

IA curve continues to shift upwards until the AD and IA curves intersect at the

potential level of output y*, that is, where AD1 and IA1 intersect. The economy

is now at a new long-run equilibrium shown by ELR 1, but with a higher steady

rate of inflation of P˙1. The central bank has responded to the demand shock

by increasing the real rate of interest from r0 to r1. If the central bank decides

that the new steady rate of inflation is too high (that is, above its inflation

target), then it would have to take steps to shift the AD curve to the left by

changing its monetary policy rule. This would lead to a recession (y < y*) and

declining inflation. As the IA curve shifts down, the central bank will reduce

real interest rates, stimulating demand, and the economy will return to y* at a

lower steady rate of inflation.

The simple model described above gives a reasonably accurate portrayal of

how monetary policy is now conducted. In Taylor’s (2000b) view this theory

‘fits the data well and explains policy decisions and impacts in a realistic

way’. Whether this approach eventually becomes popularly known as ‘new

Keynesian’ (Clarida et al., 2000; Gali, 2002) or as ‘new neoclassical synthesis’

(Goodfriend and King, 1997) remains to be seen. David Romer (2000)

simply calls it ‘Keynesian macroeconomics without the LM curve’.