How does monetary policy affect inflation?
Wages and prices will begin to rise at faster rates if monetary policy stimulates aggregate demand enough to push labor and capital markets beyond their long-run capacities. In fact, a monetary policy that persistently attempts to keep short-term real rates low will lead eventually to higher inflation and higher nominal interest rates, with no permanent increases in output or decreases in unemployment. As noted earlier, in the long run, output and employment cannot be set by monetary policy. In other words, while there is a trade-off between higher inflation and lower unemployment in the short run, the trade-off disappears in the long run. Policy also can affect inflation directly through people’s expectations about future inflation. For example, suppose the Fed eases monetary policy. If consumers and business people expect higher inflation in the future, they’ll ask for bigger increases in wages and prices. That in itself will raise inflation without big changes in employment and outp
