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This chapter introduces the role of intertemporal expectations into our analysis. Effects of current and expected inflation on long-term interest rates will be the focus of the first half of this chapter. This will be followed by a discussion of the ultimate macroeconomic meltdown—hyperinflation.

By the early 1980s, the macroeconomic landscape had changed significantly for the United States and several other Western European economies. Once-successful Keynesian discretionary demand-side stabilization policies appeared to be ineffective. The output-inflation tradeoff seemed to be no longer in evidence—expansionary fiscal and monetary stimuli only yielded additional inflation with no accompanying increase in GDP growth or employment. The Phillips curve, for all intents and purposes, appeared to be dead.

The Lucas (1973) ‘islands’ economy helped explain the procyclicality of prices and the deterioration in output-inflation tradeoffs of economies with increasing degrees of monetary ‘noise’. This model is experimentally tested by simulating an islands economy involving ‘producers’ with imperfect information, who attempt to signal-extract the real component of their observed change in prices. The results indicate that prices are procyclical and that the perceived output-inflation tradeoff worsens with increases in attempted menetary stabilization: However, it is found-that -in economies characterized by monetary indiscipline, the perceived output-inflation tradeoff becomes unresponsive to ‘reforms’ that offer lower monetary variance.

The magnitude and effects of the inflation that ravaged the Southern Confederacy have been well documented. However, there has never been any formal statistical analysis of the inflationary consequences of its monetary and fiscal policies. This paper utilizes data from the original Treasury reports to investigate the implications of war-induced fiscal expansion for debt and note issues, and for the inflation rate. The former are found to be influenced primarily by the state of the Confederate budget, while the inflation rate appears to be driven by a "confidence" index tied to developments on the military front.

In recent times, authors of macroeconomics texts have faced a series of daunting challenges. The primary challenge lies in the very nature of the subject. Monetary and fiscal policies influence wages, employment, inflation, output, interest rates, and exchange rates and affect virtually all individuals in emerging as well as in developed economies. The applicability and pervasiveness of macroeconomics have never been in doubt. In fact, it is these very aspects that pose the major challenges to authors of texts pertaining to the analysis of monetary and fiscal policies.

In this chapter, changes in the rate of inflation are finally incorporated into the ISLM-ADAS analysis. This raises the overall level of sophistication of our analysis from Chapter 7 by incorporating a “real world” aggregate supply curve into the ISLM analysis. The stage is also set for an explanation of paradigm shifts between Keynesian and supply-sider models.