What you are actually watching
Five ideas explain almost everything this macroeconomics model does. None of them require
a textbook, and all of them are the reason running an economy is harder than it looks from
outside.
The output gap drives everything else
Nearly every number on this page is downstream of a single one: the output gap.
It measures whether the economy is producing more or less than it comfortably can.
Picture an engine running above its rated speed. It works, and for a while it feels wonderful.
Unemployment falls, wages climb, everyone is busy. But the strain has to go somewhere, and it
comes out as inflation. Run the engine below its rated speed and you get the mirror image: idle
capacity, people out of work, and prices going nowhere.
So when you move the interest rate, you are not really setting inflation directly. You are
nudging aggregate demand, which moves the output gap, and inflation
follows a quarter or two behind. That indirectness is what makes monetary policy so
difficult to get right.
Why inflation gets stuck
Here is the nastiest part of the model, and of reality. Inflation depends heavily on what
people expect inflation to be.
Once workers expect prices to rise 6% a year, they ask for 6% raises. Firms expecting the same
write it into contracts and price lists. The expectation produces the outcome, and the outcome
confirms the expectation. You can watch it happen here: let inflation sit above target for a
couple of years and you will find it no longer falls just because you nudge the rate. You have
to overcorrect, and overcorrecting costs jobs.
This is why central bankers sound obsessive about "anchoring expectations". An anchor that slips
is brutally expensive to reset.
The tradeoff that broke the 1970s
The Phillips curve says you can buy lower unemployment with higher inflation, and the reverse.
For a while economists treated it almost like a menu you could order from.
Then the 1970s arrived. Oil shocks in 1973 and 1979 drove production costs up across the entire
economy, raising prices while simultaneously reducing output. Inflation and unemployment rose
together, which the simple story said should not happen. The name for it was
stagflation.
You can reproduce it. Advance until an oil price spike appears in the news feed, then try to fix
it. Raising rates deepens the growth loss you have already taken. Cutting them feeds the
inflation you already have. No setting fixes both, and that is the honest lesson rather than a
flaw in the model.
What it costs to break an inflation
Set the policy rate to 11% and hold it for three years. Inflation collapses. Unemployment climbs
toward 8%, growth stalls, and your approval rating falls apart.
That is not the model misbehaving. It is roughly what happened in the United States in the early
1980s, when the Federal Reserve under Paul Volcker pushed rates toward 20% to break double digit
inflation. The disinflation worked, and prices came back under control. It also
produced the deepest recession since the 1930s to that point, with unemployment above 10%.
The simulator will happily let you do it. It will also let you feel why almost nobody wants to.
You are steering with a delay
Policy does not land on impact. Demand carries momentum and expectations move slowly, so a rate
change you make today shows up across the following several quarters.
That means the numbers you are reacting to are already stale. It is like driving a car where the
wheel responds four seconds after you turn it. The natural instinct is to keep turning, because
nothing appears to be happening, and that is exactly how you oversteer into the opposite ditch.
Things to try
Each of these is a real problem a policymaker has actually faced.
1The soft landing
Cut the rate to 1% for two years to get the economy running hot. Now bring inflation back to
2% without letting unemployment pass 6%. This is the thing every central bank insists it can do.
2Tame a shock
Advance until an oil price spike hits. From that quarter, get inflation under 3% within three
years while keeping growth positive. Notice how much nastier a supply shock is than a demand one.
3Fiscal only
Leave the rate untouched at 3% for the whole run and steer using only spending and taxes. It
can be done, and it will show you why fiscal policy is such a clumsy stabilizer.
4The debt trap
Run spending at +10 and taxes at 10% for a decade. Growth looks wonderful. Watch the debt to
GDP tile, then try to unwind it without causing a recession.
Common questions about monetary and fiscal policy
Why does raising rates take so long to bring inflation down?
Two reasons built into the model. Demand carries momentum, so a rate change moves the output gap gradually rather than instantly. And expectations adapt slowly toward realized inflation, so once people expect high inflation it feeds into the next quarter regardless of policy. This is why central banks talk about acting early.
What is the output gap?
The difference between what the economy actually produces and what it could produce sustainably. A positive gap means the economy is running hot, which pushes inflation up and unemployment below its natural rate. A negative gap means idle capacity and rising unemployment.
What is the Taylor rule benchmark telling me?
It is a simple formula for what a stabilizing central bank would set the rate to, given current inflation and the output gap. It is a reference point rather than a command. Sitting far below it usually means you are stoking inflation, and far above it usually means you are choking growth.
Why can I not hit every target at once?
Because that is the actual problem. Cooling inflation means raising rates, which widens the output gap and raises unemployment. Cutting unemployment means stimulating demand, which pushes inflation up. The Phillips curve is exactly this tradeoff, and supply shocks make it worse by raising inflation and unemployment together.