In 1965, the aggregate price level in the United States was rising at a rate of just 11 2 percent per year. Fifteen years later, consumer price inflation had climbed more than 10 percentage points, peaking at nearly 14 percent. For the next decade it fell, at first sharply and then more slowly. By 1991, prices were increasing at a rate of less than 4 percent per year. Ten years later, the rate of increase was half that. These long-run trends are apparent in Figure 22.1 (32.0K) , which shows consumer price inflation over the last half century.

In addition to data on inflation, Figure 22.1 shows a series of shaded bars representing recessions. Note that inflation tends to fall during recessions and rise just prior to peaks in the business cycle (the left-hand edges of the shaded bars). There are some exceptions to this pattern. During 1974-75, for example, inflation rose dramatically even as the economy was slumping. And during much of the boom of the 1990s, inflation remained below its level at the end of the last recession. But in general, growth and inflation appear to be connected. Note, too, that the frequency of recessions has fallen markedly over the past half century. In the 30 years from 1955 to 1984, there were six recessions; in the 20 years since then, there have been only two. Recessions used to occur once every five years; now they occur only once in a decade.

In Chapter 20 we learned that, in the long run, inflation is tied to money growth. Over periods of several decades, high money growth leads to high inflation. But over shorter periods of months or years, changes in the rate of money growth tell us little about future movements in inflation. That is especially true when inflation is low, as it has been throughout much of the industrialized world over the past decade or two. The objective of this chapter is to explain the rise in inflation that began in 1966, the drop 15 years later, and its low level since the mid-1990s. To figure out these trends, we will need to understand the relationship between inflation and real output.

In the last chapter, we took the first step toward explaining the connection between inflation and output. There we examined the determinants of aggregate demand and their connection to monetary policy. Recall that various components of aggregate demand, especially investment, are sensitive to the real interest rate. Central bankers adjust the real interest rate in response to deviations of current inflation from its target level. Specifically, they raise the real interest rate in response to increases in inflation. Increases in the real interest rate reduce the level of investment, consumption, and net exports, lowering the economy's output.

In this chapter, we will finish the job we started in Chapter 21. To do it, we need to examine the pricing and production decisions firms make. These form the basis for the aggregate supply curve. Putting aggregate demand and aggregate supply together will show us how inflation and real output are determined, as well as what causes their levels to change over time. And because we have built monetary policy into the model, we will see how modern central banks can use their policy tools to stabilize the economy.