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We modify the Dynamic Aggregate Demand – Aggregate Supply model in Mankiw’s widely-used Intermediate Macroeconomics textbook to discuss monetary policy when the natural real interest rate is falling. Our results highlight a new role for the central bank’s inflation target as a tool of macroeconomic stabilization. We show that even when the zero lower bound is not binding, a prudent central bank will need to match every decrease in the natural real interest rate with an equal increase in the target rate of inflation in order to stabilize the risk of the economy falling into a deflationary spiral – an acute case of simultaneously falling output and inflation in which the economy’s self-correcting forces are inactive.


This work was originally presented at Northeast Business and Economics Conference, New York.

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