rary incomes policy is an excellent way of helping unemployment return to

the NAIRU more quickly™ (see also Galbraith, 1997). However, such policies

remain extremely contentious and most new Keynesians (for example,

Mankiw) do not feel that incomes policies have a useful role to play.

7.12 Keynesian Economics Without the LM Curve

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

now re¬‚ected 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:

424 Modern macroeconomics

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 in¬‚uence 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 ¬‚oating exchange rates. This rela-

tionship is ˜analogous™ to the IS curve of conventional textbook IS“LM

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

between in¬‚ation and the real rate of interest of the form:

r = bP + v

™ (7.21)

™

where P is the rate of in¬‚ation and v is a shift term. This relationship, which

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

in¬‚ation rises the monetary authorities will act to raise the short-term nomi-

nal interest rate suf¬cient 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 relation-

ship underlying the modern monetary policy model is a ˜Phillips curve™ type

relationship between in¬‚ation and GDP of the form:

P = Pt ’1 + cyt ’1 + w

™™ (7.22)

where w is a shift term. As equation (7.22) indicates, in¬‚ation will increase

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

versa. The lag in the response of in¬‚ation to the deviation of actual GDP from

potential GDP re¬‚ects the staggered price-setting behaviour of ¬rms with

market power inducing nominal stickiness. While this aspect indicates the

new Keynesian ¬‚avour of this model, the relationship also allows for expecta-

tions of in¬‚ation to in¬‚uence the actual rate.

From these three simple relationships we can construct a graphical illustra-

tion 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 in¬‚ation

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.

The new Keynesian school 425

(a)

Real

interest

rate

MP1

r1

MP0

r0

IS

Output

(b)

Inflation

™

P1

™

P0

AD

Output

Figure 7.15 Derivation of the AD curve

426 Modern macroeconomics

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

rate depends entirely on its in¬‚ation 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 in¬‚ation. 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 in¬‚ation“output space. The

intuition here is that as in¬‚ation rises the central bank raises the real rate of

interest, thereby dampening total expenditure in the economy and causing

GDP to decline. Similarly, as in¬‚ation 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

con¬dence 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 in¬‚ation 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 in¬‚ation adjustment relationship, given by equation

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

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

supply component of the model, assuming ¬rst 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*), in¬‚ation will

be steady, but when y > y*, in¬‚ation will increase and when y < y*, in¬‚ation 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 in¬‚ationary expectations. Figure

7.16 illustrates the complete AD“IA model.

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