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© 2014 Pearson Canada Inc.$24.11 APPENDIX 24.4 The Taylor Principle and Inflation Stability
- Explain how not following the Taylor principle leads to unstable inflation
Answer: A central bank that does not follow the Taylor principle will fail to raise nominal
interest rates more than the increase in expected inflation. As a result higher inflation will lead
to a decline in real interest rates. As the real interest rate falls and equilibrium output rises and
so does inflation Expected inflation rises and the SRAS shifts up and aggregate output is further
above potential output. This cases the SRAS to rise further with an even larger increase in output
and inflation. The result is an ever-accelerating inflation rate which keeps rising faster and
faster.
Diff: 2 Type: SA Page Ref: 24.4A- 1
Skill: Recall
Objective List: Appendix: The Taylor Principle and Inflation Stability