ABSTRACT
This chapter discusses the new output-inflation trade-off and its implications for the design of monetary policy. One of the hallmarks of economic analysis is the recognition that choice involves tradeoffs. Whether it’s a consumer deciding if the roominess of a sports utility vehicle is worth the lower gas mileage, or a firm deciding whether lower wages of an overseas production facility compensate for the lower worker productivity, or Congress deciding whether a new expenditure program justifies the higher taxes needed to finance it, trade-offs must be faced. Much of knowledge of variability trade-offs comes from simulations of models designed to mimic the behavior of the major industrialized economies. These models incorporate realistic inflation and output adjustment so that they can be used to study the variability trade-off implied by different rules for conducting monetary policy. Realizing that long-run effects of monetary policy determine average inflation, not average unemployment or economy’s real rate of growth, is critical to maintaining successful policy.
