Central bank simulator: interest rates, inflation and expectations
About this app
The New Keynesian three-equation model as a simulator: 48 price tags show sticky prices, curves show inflation, output and interest rates over 20 quarters. Rate move, demand boost, energy price shock, crisis at the zero bound and an announced rate rise; Taylor rule with a fan of possible paths when the response is too weak, and forward guidance.
With explain mode: an AI tutor walks you through the app, points out what matters in the scene and answers your questions.
What it is about
Michael Woodford, Nobel laureate in economic sciences 2026 with Robert E. Hall, set out in 2003 the New Keynesian model on which many central bank models build. Three equations describe households (consumption following Hall’s theory), firms (forward-looking prices that are adjusted only now and then) and the central bank (an interest rate rule). Because prices are sticky, the policy rate shifts the real rate and with it demand. A rule that responds more than one for one to inflation anchors expectations. Because everyone looks ahead, announcing future rates also has an effect.
What the app shows
On the left 48 price tags: each quarter only some firms set a new price. On the right inflation with the 2 per cent target, output with natural output and the gap, and the policy rate, the real rate and the expected rate path. Five scenarios: surprise rate move, demand boost, energy price shock, crisis at the zero bound and an announced rate rise. With a rule that is too weak, a fan of possible paths appears because the model no longer pins down a unique path. All numbers are model values.
Try it yourself
Pick the rate move and compare sticky with flexible prices: only with sticky prices does output fall. In the energy price shock output falls, yet the rule raises the rate because natural output falls more. Lower the response to inflation below one and watch the fan. In the crisis the policy rate hits the zero bound; set a promise to keep the rate at zero for longer and compare the slump with and without the promise.
Frequently asked questions
- What is the New Keynesian model?
- A macroeconomic model derived from the behaviour of households and firms that includes price rigidities. Its simplest form has three equations: a dynamic IS curve, a forward-looking Phillips curve and an interest rate rule. Central banks use extended versions for their analysis.
- What does the Taylor principle say?
- When inflation rises, the central bank should raise the policy rate by more than inflation so that the real rate rises and dampens demand. In John Taylor’s rule (1993) the factor is 1.5. If the central bank responds more weakly, the model does not pin down a unique path and expectations can become self-fulfilling.
- What is forward guidance?
- The central bank announces how it will set the policy rate in the future. Because households and firms look ahead, this has an effect today. At the zero bound, for example in the US from 2008 to 2015, central banks promised to keep rates low for longer. It requires credibility; in the simple model the announcement tends to work too strongly.
- Can the app predict real interest rate decisions?
- No. It is a teaching model with fixed model values and perfect foresight after the shock. It shows directions and mechanisms, not forecasts for a particular country.
Subject: Economics
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