1. Interest rate (r ) Inflation rate (π) Fed Reaction Rule If the Fed sees the inflation rate rising… …it moves to raise interest rates r0r0 r1r1 π1π1 π0π0 B A

2. 45 Income Aggregate Demand and Output AD 1 (with new, higher interest rate, r 1 ) E1E1 E0E0 AD 0 (with old interest rate, r 0 ) Y1Y1 Y0Y0 A B

3. Fed sees inflation rising Raises interest rates Investment is discouraged Aggregate demand falls Equilibrium GDP falls

4. Output (Y ) Inflation rate (π )Aggregate Demand Equilibrium (ADE) If inflation rises… …the Fed takes action to “cool off” the economy Y1Y1 π1π1 π0π0 Y0Y0 A B

5. Fed sees inflation falling Lowers interest rates Investment is encouraged Aggregate demand rises Equilibrium GDP rises

6. Output (Y ) Inflation rate (π ) ADE 0 ADE 1

7. Output (Y ) Inflation rate (π ) ADE 1 ADE 0 5% target 10% target

8. Output (Y ) Inflation rate (π ) Aggregate Supply Response (ASR) Maximum Capacity Y* Recession Wage- Price Spiral

9. Output (Y ) Inflation rate (π ) ASR 0 ASR 1

10. Output (Y ) Inflation rate (π ) ASR 1 ASR 0 Expansion of Maximum Capacity

11. Output (Y ) Inflation rate (π ) ASR Y* Recession ADE E0E0

12. 1963 1965 1964 Unemployment Rate (percent) Inflation (percent per year)

13. Output (Y ) Inflation rate (π ) ASR Y* ADE 1 ADE 0 E1E1 E0E0 Recession

14. 1963 1969 1968 1967 1966 1965 1964 Unemployment Rate (percent) Inflation (percent per year)

15. Output (Y ) Inflation rate (π ) ASR Y* ADE 1 ADE 0 E1E1 E0E0 Wage- Price Spiral

16. 1963 1969 1968 1967 1966 1965 1964 Unemployment Rate (percent) Inflation (percent per year) 19701971 1972 1973

17. Output (Y ) Inflation rate (π ) ASR 0 Y* ADE 0 ADE 1 E0E0 E1E1 ASR 1

18. 19701969 1975 1963 1973 1974 1976 Unemployment Rate (percent) Inflation (percent per year)

19. Output (Y ) Inflation rate (π ) ASR 0 ASR 1 ADE E1E1 E0E0 Lower Capacity

20. Output (Y ) Inflation rate (π ) ASR 0 ASR 1 ADE E1E1 E0E0

21. 19701969 1975 1983 1963 1981 Unemployment Rate (percent) Inflation (percent per year)

22. Output (Y ) Inflation rate (π ) ASR Y* Recession ADE 0 ADE 1 E0E0 E1E1

23. Output (Y ) Inflation rate (π ) ASR 0 Y* Recession ADE 0 E0E0 E1E1 ASR 1 ADE 1

24. 2000 1998 1984 1992 1989 2007 Unemployment Rate (Percent) Inflation (Percent Per Year)

25. 1992 1998 1999 1994 1997 Unemployment Rate (percent) Inflation (percent per year)

26. Output (Y ) Inflation rate (π ) ASR 1 ASR 0 ASR 2 ADE E0E0 E2E2 E1E1 Higher Capacity

27. Output (Y ) Inflation rate (π ) Classical ASR Y* ADE

28. Year Peak Trough GDP Y* AA B

29. Output (Y ) Inflation rate (π ) ASR Y* ADE A B

30. Output (Y ) Inflation rate (π ) Y* ADE 1 ADE 0 E1E1 E0E0 Classical ASR ASR 1 ASR 0