Macroeconomics

Sixth Canadian Edition

Chapter 14
Inflation: Phillips Curves and
Neo-Fisherism

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Chapter 14 Topics
• A Basic New Keynesian model that can explain inflation.
• Monetary policy in the Basic New Keynesian model.
• Achieving the central bank’s goals.
• Unconventional monetary policy:
forward guidance.
• New Keynesian model with rational expectations.
• Neo-Fisherism

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Inflation in a Basic New Keynesian Model
• Prices are sticky, and individual firms set prices in a
forward looking manner.
• Implies a Phillips curve relationship that we can add to the
output demand curve – sometimes called the “IS curve.”

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Phillips Curve
• Inflation depends on the output gap and the anticipated
future rate of inflation.

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Fisher Relation
• Define the real interest rate:

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Output Demand Curve (or “IS curve”)
• As derived in Chapter 11, the output demand curve is a
negative relationship between the real interest rate and
current output.
• In Keynesian models (originating with Hicks’s interpretation
of Keynes’s General Theory) and New Keynesian models,
the output demand curve is typically called the “IS curve.”

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Figure 14.1
The Canadian Phillips Curve, 1991–2018

The best fit to the data is a Phillips curve with i = 0.43(Y − Ym) + 1.9.

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Monetary Policy Goals
• In Canada, the renewable agreement between the Bank of
Canada and the federal government states that the Bank
should target the inflation rate at 2%, in a range of 1–3%.
• The Bank of Canada also cares about the performance of
the real economy, as specified in the Bank of Canada Act.
• In our model, this translates to:
– An inflation target i*
– A target of zero for the output gap,

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Central Bank’s Loss Function

• Assume 𝑘 > 0 and 𝑧 > 0.

• Loss function quantifies the loss for the central bank
associated with deviations from its targets – quadratic loss
function.
• Losses are symmetric – central bank cares in the same
way about positive deviations as about negative deviations
from either goal.

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Figure 14.2
The Canadian Phillips Curve, 2010–2018

The Phillips curve over this period is flat, with the best fit to the data being i = 0.15(Y − Ym) + 1.7

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Figure 14.3
The Basic New Keynesian Model

Panel (a) depicts the output demand curve (or IS curve), while panel (b) is the Phillips curve. The central
bank determines the nominal interest rate, which determines output in panel (a). Then, given equilibrium
output, current inflation is determined in panel (b) by the Phillips curve.

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Figure 14.4
The Central Bank Loss Function

This illustrates, in panel (b), the indifference ellipses for the central bank. A larger ellipse denotes larger
loss for the central bank, and the centre of each ellipse is the bliss point, at which the central bank
achieves its inflation target and the output gap is zero.

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Policy Conclusions
• The central bank may have to make tradeoffs.
• When a shock hits the economy, this may mean that it
cannot simultaneously hit its inflation target, and its real
interest rate target.

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Empirical Problems with the Phillips Curve
• Phillips curve may sometimes be hard to find in the data.
• Over a long period of time, anticipated inflation changes,
which shifts the curve.
• For inflation-targeting period, 1991-2018, can see a
Phillips curve in Canadian data.
• Much weaker relationship for 2010-2018.

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Figure 14.5
Optimal Monetary Policy If r* Falls

If the natural real rate of interest falls, and bliss was initially feasible, the central bank chooses an optimal
policy for which inflation exceeds the target and the output gap is positive.

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Figure 14.6
Optimal Monetary Policy if Future Anticipated Inflation Falls

The Phillips curve shifts down. If bliss was initially feasible, then an optimal policy response is a decrease
in the real interest rate, inflation below the target, and a negative output gap.

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What Has Caused Low Real Interest Rates
in the World?
• Bernanke: Global “savings glut.”
• Summers: “Secular stagnation,” i.e. dearth of investment
opportunities.
• Scarcity of Safe Assets: financial crisis, sovereign debt
problems, new financial regulations.

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Figure 14.7
A Liquidity Trap: The Zero Lower Bound

The nominal interest rate cannot go below zero, with a positive output gap and inflation below its target.

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Figure 14.8
Forward Guidance at the Zero Lower Bound

A promise of higher inflation in the future shifts the Phillips curve, reduces the output gap, and increases
inflation.

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Forward Guidance
• Forward guidance: a commitment by the central bank to
high future inflation.
• Given fixed anticipated future inflation, this acts to:
– lower real interest rate.
– increase current output.
– Increase current inflation.
• Central bank commitment important – promise needs to be
credible.

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New Keynesian Rational Expectations Model:
Dynamic Output Demand Relationship

• Captures intertemporal substitution: more demand for

output in current period relative to future period, the lower
is the real interest rate.

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Simplified Phillips Curve

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Rational Expectations
• Assume rational expectations: people in the model have
full knowledge of how the economy works, and use
information efficiently.
• For simplicity, assume no aggregate shocks to economy.
• So, consumers and firms can predict future inflation and
output perfectly.

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Rational Expectations Equilibrium
• Solving the model, future inflation depends on current
inflation according to:

• Indeterminacy problem: nothing to determine initial inflation

rate, so there are many equilibria.

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Figure 14.9
The NKRE model with a Constant Nominal Interest Rate

The steady-state equilibrium is at A, and there are many equilibria, as depicted that start away from the
steady state, but converge to it.

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Long Run Fisher Relation
• If the nominal interest rate is constant forever, all equilibria
converge to the same steady state, in which inflation is
determined by:

• So long-run inflation is determined by the nominal interest

rate – inflation rises one-for-one in the long run with R.

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Figure 14.10
An Increase in the Nominal Interest Rate in the NKRE Model

If there is an increase in R, then starting at A, the inflation rate rises to the new steady state at B.

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Figure 14.11
An Increase in the Nominal Interest Rate in the NKRE Model,
Part II

This figure shows the same process as in Figure 14.10, but with time on the horizontal axis and inflation
on the vertical axis.

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Neo-Fisherian Results
• In the long run, inflation increases one-for-one with an
increase in the nominal interest rate.
• Even in the short run, if the nominal interest rate goes up,
inflation goes up.

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Neo-Fisherism and Taylor Rules
• Taylor rule captures the flavor of conventional central
banking wisdom for achieving dual-mandate goals.
• Simplified Taylor rule (R responds only to inflation):

• h >1 defines the Taylor principle.

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Figure 14.12
A Taylor Rule under the Taylor Principle

There are two steady states, one at A in which the central bank achieves its inflation target and another at
B where the central bank gets stuck at the zero lower bound with too-low inflation.

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Figure 14.13
Inflation Dynamics Under the Taylor Principle

This illustrates Taylor rule perils. There are many equilibria converging to the undesired steady state at B,
in which inflation perpetually undershoots the inflation target.

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Perils of the Taylor Rule
• Under the Taylor principle there are two steady states:
– i=−r*, R=0, and the central bank perpetually undershoots its
inflation target.
– i=i*, R=i*+r*, and the central bank hits its inflation target.
• Problem: the desired steady state is unstable, with many
equilibria converging to the undersired steady state –
central banker forever stuck, thinking that R=0 will
increase i.

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Neo-Fisherian Monetary Policy Rule
• If inflation below target, increase the nominal interest rate.
• If inflation above target, increase nominal interest rate to
offset incipient future inflation.
• Implies that central bank will, at worst, undershoot the
inflation target for one period, then hit the target forever.

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Figure 14.14
Inflation under a Neo-Fisherian Monetary Policy Rule

Inflation can be lower than the inflation target for one period, then it returns to the target and stays there
forever.

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