Conceptual Framework

The aggregate demand (AD) curve represents the general equilibrium of the money market (represented by the LM curve) and the goods market (represented by the IS curve). The properties and effects of the slope and shift parameters of these two curves were discussed in Chapter 2 on the theory of inflation. In the standard Keynesian model, the intersection of the IS and LM curves represents the equilibrium interest rate and the output with the assumption that inflation is zero, such that the real and nominal interest rate are equal. The other important assumption is that the central bank targets the money supply. Thus, the IS-LM model is not useful for analyzing the effects of inflation unless an aggregate supply (AS) curve is added to make it an IS-LM-AS system or AD-AS system. The AD schedule is downward sloping derived from IS-LM in the output-price plane for a given money stock. In the standard form, the AS schedule is upward sloping in the output-price plane where the assumption is the higher price leads to higher output, a notion already discussed in Chapter 2.

Thus, in the standard literature, the AD and AS curves are considered in the output-price plane. These are not in inflation-output planes, which is more interesting. The important difference here is that inflation may still fall while prices continue to rise. The expected inflation n e is assumed to be determined outside the model in a standard IS-LM-AS system. This would lead to an upward sloping AD curve in an output-expected inflation plane. This happens because of the vital assumptions that consumption and investment are both inversely related to the real interest rate, and the real interest rate falls with an increase in expected inflation.

However, this assumption may not produce as clear a picture as desired because of their interrelationship through savings.

The above assumption means that general consumption, particularly the consumption of consumer durables, will increase in anticipation of future inflation. This will be more so if the society is near an autonomous consumption level. This increase in consumption will cause a drop in savings and funds available for future investment. Considering that investment is directly dependent on savings, the fund rate is bound to bid up which would then reduce investment demand and growth in general as seen empirically to happen in the Indian case in Chapter 4. In a situation of scarcity of capital, the investment effect may dominate the consumption effect and the AD curve would then be downward sloping in the inflation output plane. This leaves the important observation that the nominal interest rate is in fact dependent on expected inflation. In the case of the United States (USA), Taylor (1993b) found that the Federal Reserve’s setting of the funds rate over the past 15 years is well described by a simple function of inflation and output alone. Therefore, the major policy concern of central bankers is to set the interest rate near such that goal variables hit their targets. The money supply should be a secondary concern.

In a recent article, Römer (2000) has highlighted the inconsistency associated with the concept of conventional IS-LM-AS analysis and the practices of the central banks. As previously pointed out, in the common textbook approach of deriving AD curve, the assumption is that the central bank targets money supply. Thus, for a given stock of money, the LM curves shifts down to the right along the IS curve with a fall in the price level as it increases the real stock of money. Thus, for a given expected inflation, both nominal and real interest rates fall, giving rise to different levels of equilibrium aggregate demands and hence different equilibrium output levels. In the process, what happens to the real interest rate if expectations about inflation were not fixed is not clear. In Römer’s opinion, this assumption is far away from the point of view of practices of modern central banking. Even countries which resort to monetary targeting tailor monetary targets with an eye on movements in the short­ term nominal interest rate and inflationary expectations55. In developing countries,

55 For example, see Clarida, et al. (1998); Bernanke and Mihov (1997); Bernanke and Mihov (1995). These studies indicate that in the case of Bundesbank, the adjustments to interest rate in response to the variations in output, inflation and exchange rate are more prominent than the adjustment in money supply, which is the declared target of monetary policy.

administering the interest rate is often justified due to the presence of an imperfect capital market.

As pointed out in Chapter 1, the main objective of central banking is to achieve maximum sustainable growth at low and stable inflation. Römer (2000) argues that realization of these objectives can be better explained with an assumption that central banks follow a real interest rate rule rather than target the money supply. It took some time for the Indian central bank to be able to realize this but with the financial sector reform commencing in the early 1990s it has been attempting to establish a clear-cut interest rate as the main instrument of monetary policy. However, the real interest rate has always been important for the expansion of credit needs commensurate with growth targets, while at the same time doing every thing possible to contain inflation.

Given the fact that the interest rate is more important to central bankers than the money supply, Römer (2000) has proposed that the LM curve of the IS-LM framework may be replaced by the Monetary Policy (MP) curve, which is a relationship between the interest rate and inflation in its simplest form. However, central banks may also prefer to include other variables in the monetary policy function, particularly output, in order to reduce the fluctuations in these variables. In the short run, central bank changes the nominal interest rate but in the medium-term, they must reconcile with the real rate. Therefore, Römer calls it the real interest rate rule, which is a flat curve for a given level of inflation when only inflation is included in the monetary policy function. When the monetary policy schedule includes both inflation and output, the MP curve would be upward sloping. The important assumption here is that, with an objective of dampening output fluctuations, central banks are likely to cut the real interest rate when output falls and raise it when output rises.56 This assumption means r = r (Y, 7t), with the function increasing in both arguments and giving rise to an upward sloping monetary policy curve. Further, as it is believed that high output tends to increase inflation while low output decreases it, such a policy would also dampen inflation fluctuations.

The IS curve remains a conventional IS curve sloping downward in the real interest rate output plane. By assumption, an increase in inflation causes the central bank to raise the real rate. Thus, the MP curve shifts up. The shift of the MP curve

56 With long lags output may be an indicator of inflationary expectations.

causes the economy to move up along the IS curve, causing output to fall. Applying the condition of output equals aggregate demand the inverse relationship between inflation and aggregate demand (AD) is thus established as shown in Figure 5.2.

Figure 5.2 Derivation of aggregate demand schedule in inflation-output plane

Notes: In the above diagram r is the real interest rate, n is the annual percentage inflation, Y is the output, MP is the monetary policy schedule, AD is the aggregate demand schedule. Diagram is based on Römer (2000)

All the factors that can shift the conventional IS-curve are still applicable. However, the role of a change in the stock of money is complicated. In the conventional IS-LM set-up an increase in money stock would shift the AD-curve proportionately to the right. Now, an increase in the money stock at a given level of inflation would lower the real interest rate due to lowering of the nominal rate. With a lower nominal rate the AD curve would shift to the right for all levels of inflation, provided prices have some inertia and do not adjust instantaneously, which is a realistic assumption. Thus, it is seen from the above discussion that downward sloping aggregate demand curve in the inflation output plane can be justified in both the conventional and new set-up of Keynesian analysis. For the Indian data, such a

possible aggregate demand curve is estimated in simple form in the following section.