Chapter 3: Inflation, Unemployment, and Monetary Rules

Detailed Chapter Notes — IS-PC-MR Model

Chapter Overview
This chapter extends the macroeconomic model from Chapter 2 by introducing the Phillips
curve (PC) and the central bank's monetary rule (MR), creating the full 3-equation IS-PC-MR
model. The goal is to analyse inflation and monetary rules used by contemporary central banks
— specifically, how they set the interest rate to stabilize the economy around an inflation target.
Key insight: when unemployment is at its equilibrium rate (ERU), inflation is constant. Below
the ERU, inflation rises; above it, inflation falls. This trade-off only exists in the short run — wage
setters react to protect their real wages. In the long run, the Phillips curve is vertical.
The chapter is organized into:
1. Inflation and Phillips curves
2. Monetary rules and the 3-equation IS-PC-MR model
3. Medium-run equilibrium under two monetary policies
4. Inflation in the IS/LM model
5. Conclusions
6. Appendix: Friedman's competitive model

Section 1: Inflation and Phillips Curves

What is Inflation?
Inflation (π) is the rate of change of prices:

P − P−1
π≡
​

P−1 ​

Where P is today's price level and P₋₁ is last period's price level. Unless inflation is negative
(deflation), the price level does not fall. High inflation tends to be volatile, undermines price
signals, and is costly to reduce (unemployment must rise). These costs motivate inflation-
targeting central banks.
1.1 Inflation Inertia
Empirical evidence: changes in output (employment) are followed by changes in inflation —
"output leads inflation."
Inflation depends on:
Past inflation, π₋₁ (inflation inertia)
The gap between current unemployment and the ERU

Two interpretations of the lagged inflation term:

1. Adaptive expectations: Wage setters expect this period's inflation to be what it was last
period. Under simple adaptive expectations (a = 1): π^E = π₋₁
2. Inflation inertia: Wage setters incorporate past inflation into their current money wage
claim to make up for any erosion in living standards (real wage). This is the book's primary
interpretation.

Adaptive expectations formula:

π E = π−1
E
​
E
+ a(π−1 − π−1 ) ​ ​

When a = 1 (past mistakes fully corrected): π^E = π₋₁

The book uses the inertia interpretation and denotes lagged inflation as π^I (inflation inertia),
where:

π I = π−1 ​

Important assumption: Wage setters are NOT able to incorporate expected future changes to
inflation in their current bargain. They focus on compensating for past inflation.

1.2 Deriving the Phillips Curves

Starting point: At equilibrium employment E₁ (the ERU), both the WS and PS curves cross and
both wage and price setters are content. At equilibrium, inflation is constant.
Numerical Example (inflation = 4%):
Employment at E₁ (ERU); lagged inflation = 4%
Wage setters need a 4% money wage rise to maintain real wages
Firms set prices as a mark-up on unit labour costs: P = (1 + μ)(W/λ)
With constant productivity (λ): ΔP/P = ΔW/W
Money wages rise 4% → prices rise 4% → inflation stays at 4% (Case 1: Constant inflation)
When employment is ABOVE ERU (E₂):
The WS curve lies 2% above the PS curve (a 'gap' = +2%)
Wage setters require 4% to maintain real wages plus 2% to raise real wages → money wages
rise 6%
Firms raise prices by 6% to preserve profit margins
Inflation rises from 4% to 6% → rising inflation (Case 2)

When employment is BELOW ERU (E₀):

Workers' bargaining power is weakened; WS curve is 2% below PS curve (gap = −2%)
Money wage increase = 4% − 2% = 2%
Firms raise prices by 2%
Inflation falls → falling inflation (Case 3)

Summary (Table 3.1):

Case Employment 'Gap' Inflation Result

1 E₁ (ERU) 0 Constant at 4%

2 E₂ (above ERU) +2% Rising: 4%→6%→8%→10%

3 E₀ (below ERU) −2% Falling: 4%→2%→0%→−2%

Okun's Law: The relationship between output growth and unemployment: a 1% change in
output growth above or below trend tends to be associated with a fall or rise in the
unemployment rate of less than 0.5 percentage points. This is due to:
Labour hoarding: firms keep workers on payroll in short-run slumps
Changes in labour force participation: economically inactive people who enter/exit the
labour market

Phillips Curve Diagram (Figure 3.2)

The inertia-augmented Phillips curve is drawn with inflation on the vertical axis and output (y)
on the horizontal axis. It is related to the WS/PS diagram drawn directly below it.
Equation:

π = π I + α(y − ye )
 π = π−1 + α(y − ye ) (Inertia-augmented Phillips curve)
​ ​ (3.1)

Where:
α is a positive constant (sensitivity of inflation to output gap)
y − yₑ is the output gap (positive if above equilibrium, negative if below)
The slope of the Phillips curve depends on α, which reflects the slope of the WS curve
The height of each Phillips curve is determined by the lagged inflation rate (π^I = π₋₁)

Each Phillips curve is labelled PC(π^I = x%), meaning the curve is valid when last period's
inflation was x%.
Key properties:
The Phillips curve shifts up when π^I rises and shifts down when π^I falls
The Vertical Phillips Curve (VPC) passes through yₑ (equilibrium output) — at this point,
inflation equals last period's inflation

1.3 Phillips's Original Curve

The original Phillips curve (A.W. Phillips, 1958) — based on UK data 1861–1957 — showed a
stable downward-sloping relationship between unemployment and the rate of change of money
wages (used as a proxy for inflation). This appears when:
The average inflation over many years is zero
Shocks to aggregate demand are random (sometimes positive, sometimes negative)
Wage setters treat inflation as temporary and do not incorporate it into wage claims

In Figure 3.3, the 'original' Phillips curve connects the ERU points across different inflation
levels. It is downward sloping because higher unemployment is associated with lower inflation
and vice versa.

1.4 Phillips's Original Curve: Cannot Be Exploited

The Lucas Critique (Lucas, 1976):
If the government tries to exploit the stable Phillips curve (e.g. by using expansionary policy to
move from point A to point B — lower unemployment, slightly higher inflation), the following
occurs:
1. Workers notice that inflation is rising persistently (not just random)
2. Workers incorporate the expected 2% inflation into their wage claims
 3. The Phillips curve shifts upward
4. The lower unemployment rate becomes permanently associated with ever-increasing
inflation
5. The stable trade-off disappears

Conclusion: A stable Phillips curve only existed because governments did not systematically try
to exploit it. The Vertical Phillips Curve (VPC) is the correct long-run representation — the
policy maker cannot choose any point other than on a vertical line above the ERU.
Note: If governments cease to try to run the economy below the ERU, the original stable
Phillips curve trade-off may reappear in the data.

1.5 Disinflation Is Costly

From the Phillips curve equation: π = π₋₁ + α(y − yₑ)
If (π − π₋₁) < 0 (i.e., we want to reduce inflation), then:

α(y − ye ) < 0 ⇒ y < ye

​ ​

Output must fall below equilibrium to bring inflation down. This is because:
Inflation inertia means current inflation = last period's inflation + output gap effect
To reduce inflation, unemployment must be above the ERU
A slacker labour market means workers can't maintain real wages → lower wage and price
inflation

Diagram (Figure 3.5):

Economy at point B: high inflation of 8%, on PC(π^I = 8)
Central bank wants to reach target of 2%
Must move to a point left of B (higher unemployment)
Inflation falls step by step as the Phillips curve shifts down
Eventually reaches PC(π^I = 2) and point A at the ERU

Costless disinflation is impossible under inflation inertia. If the influence of the past could be
wiped away, the PC(π^I = 8) could shift directly to PC(π^I = 2) — jumping from B to A without
any rise in unemployment.

1.6 Disinflation and Central Bank Preferences

The central bank faces a choice along the initial Phillips curve of how fast to disinflate:
 Extreme (point C): Bring inflation down to target in one period — very steep rise in
unemployment. "Cold turkey."
Gradual (point F): Allow a smaller rise in unemployment, slower path to target.

Central bank indifference curves represent the trade-off between:

Deviations of inflation from π^T
Deviations of output from yₑ (i.e., unemployment from ERU)

The more inflation-averse the central bank, the flatter its indifference curves → willing to accept
more unemployment to get inflation down faster. Such a bank chooses point D on PC(π^I = 8).
A less inflation-averse bank has steeper indifference curves → chooses point F.
Both banks ultimately return the economy to A (π = π^T, y = yₑ). Their indifference curves shrink
to a point at A.

1.7 Costless Disinflation and Rational Expectations

Conditions for costless disinflation:
1. Inflation inertia is absent — no nominal rigidities; rational expectations hold
2. Central bank's inflation target is credible — believed by all market participants

Under rational expectations: π^E = Eπ = π^T (expected inflation equals the announced target,
up to a random shock)
Phillips curve under rational expectations:

π = π T + α(y − ye ) + ϵ
​

Lucas surprise supply equation:

1
y = ye + ​ ​(π − π E ) + ξ = ye + ξ (3.2)
α

Where ξ (ksi) is a random error. Output only deviates from equilibrium when there is a surprise
to inflation (an unanticipated shock). This is called the Lucas surprise supply equation (after
Robert Lucas, Nobel 1995).
Key insight: Under rational expectations, only unanticipated changes in inflation can affect
output. Systematic monetary policy is ineffective in altering the level of activity. There is no
need for stabilization policy because the economy returns directly to equilibrium after a shock.
Contrast with inertia model:
 Inertia model: ΔAD → Δy relative to yₑ → Δπ relative to π₋₁ (demand shock → output gap →
inflation change)
Lucas/rational expectations: Δπ relative to π^E → Δy relative to yₑ (inflation surprise →
output deviation)

Why central banks still engage in stabilization policy: Because of the presence of inflation
inertia, a variety of economic disturbances shift the economy away from equilibrium and it does
not return costlessly. Therefore, central banks do engage in systematic monetary policy.

Section 2: Monetary Rules and the 3-Equation IS-PC-MR Model

2.0 Introduction to the 3-Equation Model
The three equations are:
1. IS equation — aggregate demand
2. Phillips curve (PC) equation — aggregate supply / inflation
3. Monetary rule (MR) — central bank's policy response

The emphasis is on diagrams and intuition. The equations are:

(1) IS equation (simplified):

y = A − ar (IS equation)

Where A is the sum of exogenous multiplied-up demands (private and public sector), and r is the
real interest rate.
Stabilizing interest rate r_s: the rate that equates y to yₑ:

ye = A − ars
​ ​

IS in output gap form:

y − ye = −a(r − rs ) (IS, output gap form)

​ ​

Output deviates from equilibrium to the extent that the interest rate deviates from the stabilizing
rate. The central bank cannot bring about an instantaneous change in output by altering the
interest rate — it takes time for interest rate changes to feed through to investment and output.
(2) Inertia-augmented Phillips curve (PC):

π = π−1 + α(y − ye ) (Phillips curve, PC)

​ ​
(3) Monetary rule (MR):

y − ye = −b(π − π T ) (Monetary rule, MR)

​

This shows the combination of output and inflation that the central bank will choose given the
Phillips curve it faces. When inflation is high, the central bank will choose to reduce aggregate
demand (raise interest rate) to bring inflation down.
A higher b → more inflation-averse central bank.

The MR Line in the Phillips Diagram

The MR is constructed by finding the central bank's best output-inflation combination along
each Phillips curve — i.e., the tangency between the central bank's indifference curves and the
relevant Phillips curves.
Key role of the MR line: It shows the path along which the economy will be guided by central
bank actions to return to equilibrium output at target inflation (yₑ, π^T).
Whenever the economy is shifted from (yₑ, π^T) equilibrium by an aggregate demand or supply
shock, the job of the monetary authority is to use the interest rate to get the economy onto the
MR line; once on the line, it continues to adjust the interest rate until the economy returns to (yₑ,
π^T).

The MR line passes through (yₑ, π^T). The MR equation always holds at this point.

2.2 An Inflation Shock

Setup: Economy at A: y = yₑ, π = 2% (target). An inflationary shock pushes inflation up to 4%.
Sequence of events (Figure 3.8):
Economy moves to point B on PC(π^I = 4)
Central bank uses MR to find its preferred point on PC(π^I = 4): point C
To achieve point C, the central bank raises the interest rate to r' (from IS diagram), cutting
output below yₑ (point C' in IS diagram)
This raises unemployment above ERU
Next period: inflation falls to 3%, defining PC(π^I = 3)
New preferred point on PC(π^I = 3): F'
Central bank gradually reduces interest rate as it moves along the MR line toward Z
Eventually the economy returns to equilibrium at Z: y = yₑ, π = 2%
The central bank behaves in an active, rule-based fashion: frequent adjustments of the interest
rate are required by the monetary policy rule.

2.3 A Temporary Demand Shock

Definition: IS curve shifts to IS' for only one period, then returns to IS.
Sequence (Figure 3.9):
Economy starts at A: y = yₑ, π = 2%
IS shifts right to IS': output rises to y' > yₑ → moves to point B on PC(π^I = 4)
Central bank identifies preferred point C on PC(π^I = 4)
Raises interest rate to r' → output falls back below yₑ (point C in IS diagram)
Since IS is temporary and has returned to IS, the stabilizing rate is still r_s
Adjustment path down MR line to Z (= A at the new equilibrium) is exactly as in the
inflation shock case

Note: The central bank is forward looking and takes all available information into account. It
raises the interest rate in response to the aggregate demand shock because it can work out the
consequences for inflation.

2.4 A Permanent Demand Shock

Definition: IS curve shifts to IS' and stays there.
Key difference: The stabilizing interest rate has now risen to r'_s (because a higher IS curve
requires a higher real interest rate to keep output at yₑ).
Sequence (Figure 3.10):
Economy starts at A: y = yₑ, π = 2%; IS at stabilizing rate r_s
IS shifts permanently to IS': output goes to y', economy moves to B
Central bank raises interest rate to r' (considerably higher than in the temporary shock
case) to achieve point C
Once on the MR line, adjustment takes place in the usual way
New equilibrium at Z (Phillips diagram) / Z' (IS diagram): y = yₑ, π = 2%, but r = r'_s > r_s

With a permanent demand shock, the new stabilizing interest rate is higher than the old one,
reflecting the permanently higher level of autonomous demand.
2.5 The MR Line and the Real Interest Rate
Illustration: In the permanent demand shock case, the central bank sets the nominal interest
rate to achieve the desired real interest rate on the IS curve.
Important insight: The real interest rate is what matters. If the central bank keeps the real
interest rate unchanged at r_s, output stays at y' and inflation continues rising. If the central bank
keeps the nominal interest rate unchanged, higher expected inflation (π^E) lowers the real
interest rate (since r = i − π^E), further boosting output — moving even further from the inflation
target.
Therefore, the central bank must raise the nominal interest rate by more than the rise in
expected inflation in order to raise the real interest rate.

2.6 Sacrifice Ratios and Disinflation Strategies

Two disinflation strategies:
Cold turkey (b → ∞): Maximum inflation aversion — bring inflation back to target
immediately, regardless of unemployment cost. MR is horizontal.
Gradualism (b is low): Smaller rise in unemployment, slower return to target. MR is less
steep.

Key result with linear Phillips curves: The sacrifice ratio (cumulative unemployment to
achieve a given reduction in inflation) is the same under both strategies — independent of the
degree of inflation aversion b.
Proof (Figure 3.11):
Cold turkey (MR₁): Output falls from yₑ to y₀ for one period; cumulative unemployment = yₑ
− y₀
Gradualism (MR₂): Output falls to y₁ in period 1, then y₂ in period 2, etc.; cumulative = (yₑ −
y₁) + (yₑ − y₂) = yₑ − y₀

The only difference is the time pattern: high short-term unemployment vs. lower
unemployment over a longer period.
With convex (non-linear) Phillips curves (Figure 3.12): The sacrifice ratio is higher for a more
inflation-averse central bank. Convex Phillips curves reflect that inflation is less sensitive to
unemployment at high unemployment levels. Pushing unemployment up very high takes the
economy into a region where inflation responds less to unemployment. Hence a cold turkey
strategy produces a more rapid return to target but at greater cumulative unemployment cost
than a gradualist strategy.
Summary: With linear PCs, sacrifice ratios are equal. With convex PCs (empirically more
realistic), cold turkey is costlier in total unemployment terms.
Section 3: Medium-Run Equilibrium Under Two Monetary Policies
(Referenced but primary treatment is in earlier sections — Section 3 in the book covers
equilibrium under interest rate rule vs. money supply rule.)
Under the interest rate rule (IS-PC-MR): Medium-run equilibrium has:
y = yₑ, π = π^T (inflation target)
The LM curve is present in the background — the central bank must keep the money
market in equilibrium as it sets the nominal interest rate

Under the money supply rule (IS/LM): Medium-run equilibrium has:

y = yₑ, π = growth rate of money supply (π_M)

The equilibrium only differs in what determines the medium-run inflation rate: the inflation
target in IS-PC-MR vs. money supply growth rate in IS/LM.

Section 4: Inflation in the IS/LM Model

4.1 IS/LM vs. IS-PC-MR
The IS/LM model presents a different picture of policy making from the 3-equation IS-PC-MR
model:

Feature IS-PC-MR IS/LM

Monetary policy Interest rate rule (reaction function) Fixed money supply growth

Central bank role Active, forward-looking Passive

Policy tool Nominal interest rate Money supply

Response to shocks Active adjustment Passive adjustment via money market

When using an MR, the central bank is forward looking, forecasting inflation implications of
disturbances and setting the interest rate to guide the economy back to equilibrium. A money
supply rule implies monetary policy is passive.

4.2 Permanent Aggregate Demand Shock in IS/LM

With a constant money supply growth rate, the adjustment path after a permanent demand
shock is:
 1. IS shifts right → output rises → money demand rises → LM curve stays fixed → interest rate
rises along LM
2. Higher output and employment → inflation rises (Phillips curve)
3. Higher inflation reduces real money supply → LM shifts left → interest rate rises further
4. Inflation must end up back at its original level — but since inflation has gone up, output
must fall below yₑ during the adjustment
5. A counter-clockwise spiral is traced in the Phillips diagram (Figure 3.13)

The adjustment path is more protracted in IS/LM than with an interest rate rule because:
With a monetary policy rule, the central bank actively intervenes to guide the economy to
the new medium-run equilibrium once it is on the disinflation path
With a fixed money supply, adjustment is slower and more circuitous

Section 5: Conclusions
Summary of the IS-PC-MR Model:
The chapter built a framework for systematically investigating shocks and policies affecting the
economy. To elements from Chapter 2 (IS curve, LM curve, WS/PS curves, ERU), we added:
Phillips curves (derived from WS/PS diagram)
Monetary rule, MR (derived from central bank's output-inflation trade-off)

Key Results:
On Phillips curves:
The original Phillips curve showed a stable empirical relationship between unemployment
and inflation
However, if a policy maker tries to exploit this relationship by choosing a lower
unemployment rate in exchange for a higher inflation rate, the stable relationship
disappears (Lucas critique)
There are no lags in wage and price setting and wage/price setters are able to make the best
use of available information → policy maker cannot choose a rate of unemployment below
the ERU without ever-increasing inflation
The Phillips curve is therefore vertical in the long run

On the 3-equation model — summary of a temporary positive demand shock:

1. An upward shift in consumer confidence leads to a rise in output and a fall in
unemployment below the ERU
 2. Lower unemployment implies inflation will rise above the central bank's target
3. The central bank raises the interest rate to push unemployment above equilibrium in order
to bring inflation back down to target
4. Once the economy is on the MR line, the central bank gradually reduces the interest rate
and the economy returns to the ERU with inflation at target and interest rate at stabilizing
level r_s

Medium-run equilibrium:
In IS-PC-MR: π = π^T (inflation target); y = yₑ
In IS/LM: π = π_M (money supply growth rate); y = yₑ
Both models work in broadly similar ways; the difference is in what determines the
medium-run inflation rate and the adjustment path

When monetary policy becomes ineffective:

The monetary rule will become ineffective if the nominal interest rate approaches zero
(zero lower bound problem). Other policy instruments will then be needed.

Appendix: Friedman's Model — Inflation in the Competitive Model

Context: Milton Friedman's 1967 presidential address to the American Economics Association
presented an alternative, highly influential model using competitive labour markets and
imperfect information.
Friedman's "natural rate of unemployment": There is a unique unemployment rate at which
inflation is constant — the "natural rate". This parallels the ERU concept in the chapter's model.
Key mechanism (imperfect information):
Workers have imperfect information about the general price level
If the government tries to reduce unemployment below the natural rate, demand for output
exceeds supply → prices rise
Workers observe that the price level is above expected: π > π^E (inflation surprise)
Firms interpret higher prices as rising relative demand for their product → they want to hire
more workers
Workers require a higher real wage of w* but will supply labour E₁ only if the real wage is
lower at w₁
This apparent contradiction is resolved by the inflation surprise: firms demand E₁ workers
at the real wage w₁ (because nominal wages haven't risen as fast as prices), while workers
supply E₁ because they expect the real wage to be w* (not realizing prices have risen)
Results:
Unemployment can be temporarily below the natural rate while π > π^E
The short-run Phillips curve is upward sloping (in output/inflation space) — same
qualitative result as in this chapter
The long-run Phillips curve is vertical at the natural rate
In the short run, there is a trade-off between unemployment and inflation (attainable at the
cost of rising inflation)

Parallel to Lucas surprise supply equation:

1
y = ye +​ (π − π E )
​

This is the same structure as equation (3.2). Both Friedman's model and the rational
expectations model produce the same result that only unanticipated inflation affects output.

Key Equations Summary

Equation Formula Name

Inflation rate π ≡ (P − P₋₁)/P₋₁ Definition

Adaptive expectations π^E = π^E₋₁ + a(π₋₁ − π^E₋₁) Adaptive expectations

Simple adaptive π^E = π₋₁ Simple adaptive expectations

Inertia-augmented PC π = π^I + α(y − yₑ) = π₋₁ + α(y − yₑ) Phillips curve (PC)

Expectations-augmented PC π = π^E + α(y − yₑ) Expectations-augmented PC

IS equation y = A − ar IS

IS output gap form y − yₑ = −a(r − r_s) IS (output gap form)

Monetary rule y − yₑ = −b(π − π^T) Monetary rule (MR)

Rational expectations PC π = π^T + α(y − yₑ) + ε Phillips curve (rational expectations)

Rational expectations π^E = π^T Rational expectations of inflation

Lucas surprise supply y = yₑ + (1/α)(π − π^E) + ξ = yₑ + ξ Lucas surprise supply equation (3.2)
Key Diagrams Summary
Figure Description

3.1 WS/PS diagram — upward/downward pressure on inflation when employment is above/below

ERU

3.2 Deriving the Phillips curves from the WS/PS diagram — family of PC curves for different π^I
values

3.3 The 'original' Phillips curve — downward sloping when average inflation is zero

3.4 Phillips's original data: UK 1861–1913

3.5 Disinflation is costly — path from B (π=8%) to A (π=2%) via higher unemployment

3.6 Disinflation and central bank preferences — indifference curves; inflation-averse vs. less
inflation-averse

3.7 The monetary rule: the MR line in the Phillips diagram

3.8 Inflation shock and the monetary rule (IS diagram + Phillips diagram)

3.9 Temporary aggregate demand shock and the monetary rule

3.10 Permanent aggregate demand shock and the monetary rule

3.11 Disinflation strategies and sacrifice ratios: cold turkey vs. gradualism (linear PCs)

3.12 Sacrifice ratios with convex (non-linear) Phillips curves

3.13 Aggregate demand shock: central bank holds money growth rate constant (IS/LM adjustment —
spiral path)

Key Concepts and Terminology

ERU (Equilibrium Rate of Unemployment): The unemployment rate at which inflation is
constant; determined by the intersection of WS and PS curves
Inflation inertia: The tendency for inflation to persist because wage setters incorporate
past inflation into current money wage claims
Phillips curve (PC): The relationship between inflation and output (or unemployment)
Inertia-augmented Phillips curve: π = π₋₁ + α(y − yₑ)
Vertical Phillips curve (VPC): Long-run Phillips curve; vertical at yₑ — no long-run trade-
off between inflation and unemployment
Lucas critique: The argument that stable empirical relationships like the original Phillips
curve break down when exploited by policy
Rational expectations: Expectations formed using all available information; no systematic
errors
Lucas surprise supply equation: y = yₑ + ξ when expectations are rational and policy is
credible
Monetary rule (MR): Central bank's policy reaction function; y − yₑ = −b(π − π^T)
Stabilizing interest rate (r_s): The real interest rate that equates output to yₑ
Cold turkey: Disinflation strategy where inflation is brought to target immediately (b → ∞)
Gradualism: Disinflation strategy with a slower, more gradual approach (low b)
Sacrifice ratio: Cumulative unemployment required to achieve a given reduction in
inflation
Inflation target (π^T): The central bank's desired rate of inflation
IS-PC-MR model: The 3-equation model combining IS curve, Phillips curve, and monetary
rule
Reaction function: Another name for the monetary rule — the formula governing how the
central bank reacts to inflation/output deviations