ECON 3440 Lecture Notes - Lecture 42: Aggregate Supply, Aggregate Demand, Taylor Rule

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Suppose the contracts are signed & the economy is at equilibrium at point b. Suppose after these contracts are signed the central bank unexpectedly target inflation from t: to t, suppose appropriate fiscal austerity accompanies this in target inflation to make the new target credible. Hence, ad shifts to ad1, which intersects y*y* at t. Recall from taylor rule (r=r*+ x( - t) + x(y-y*)) when target inflation , the central bank the r. this investment & net exports. Hence, a new equilibrium is reached at d. Now, when time for renegotiating arrives workers & firms will set expected inflation at t. The new contract will specify a small rate of in nominal wage (at rate t. This will then result in a new as at as1 which then gives us fiscal equilibrium at f, with actual inflation at its target level t. Forward guidance advocates announcing policies in advance in order to avoid surprises.

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