Inflation Dynamics and the New Keynesian Phillips Curve

www.philadelphiafed.org to the financial instruments that help guard savings from being eroded by inflation.1 Also, households and firms often write contracts that are stated in dollar amounts (nominal terms). A worker may, for example, sign a contract to work over the upcoming year for a fixed dollar amount. If inflation turns out to be higher than what was expected at the time the contract was made, the worker may find he is unable to purchase as many goods and services as planned because his inflation-adjusted income is lower than expected. Stable inflation would help mitigate such problems. A 1977 amendment to the Federal Reserve Act codified the importance of low and stable inflation as a goal for monetary policymakers. The amendment states that the Fed’s mandate is “to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates.” Moderate long-term interest rates require low and stable inflation, on average. But how does the Fed control inflation? It cannot simply dictate that the rate of price increase will be, say, 2 percent. Rather, monetary policymakers use instruments such as a short-term interest rate to guide the economy with the aim of achieving an inflation objective. To help guide their decisions, monetary policymakers benefit from having a reliable theory of how inflation is determined: a theory that relates the setting of their instrument to the unexpected events Inflation Dynamics and the New Keynesian Phillips Curve*