luck " from a reduction in the volatility of shocks was more important in stabilizing output. level. at other times, a tightening of the stance of monetary policy has prevented the economy from overheating and generating a boom - bust cycle in the level of employment as well as an undesirable upward spurt of inflation. one critical precondition for effective central - bank easing in response to adverse demand shocks is anchored long - run inflation expectations. otherwise, lowering short - term interest rates could raise inflation expectations, which might lead to higher, rather than lower, longterm interest rates, thereby depriving monetary policy of one of its key transmission channels for stimulating the economy. the role of expectations illustrates two additional basic principles of monetary policy that help explain why stabilizing inflation helps stabilize economic activity : first, expectations of future policy actions and accompanying economic conditions play a crucial role in determining the effects of current policy actions on the economy. second, monetary policy is most effective when the central bank is firmly committed, through its actions and statements, to a " nominal anchor " – such as to keeping inflation low and stable. a strong commitment to stabilizing inflation helps anchor inflation expectations so that a central bank will not have to worry that expansionary policy to counter a negative demand shock will lead to a sharp rise in expected inflation – a so - called inflation scare ( goodfriend, 1993, 2005 ). such a scare would not only blunt the effects of lower shortterm interest rates on real activity but would also push up actual inflation in the future. thus, a strong commitment to a nominal anchor enables a central bank to react more aggressively to negative demand shocks and, therefore, to prevent rapid declines in employment or output. unlike demand shocks, which drive inflation and economic activity in the same direction and thus present policymakers with a clear signal for how to adjust policy, supply shocks, such as the increases in the price of energy that we have been experiencing lately, drive inflation and output in opposite directions. in this case, because tightening monetary policy to reduce inflation can lead to lower output, the goal of stabilizing inflation might conflict with the goal of stabilizing economic activity. here again, a strong, previously established commitment to stabilizing inflation can help stabilize economic activity, because supply shocks, such as a rise in relative energy prices, are likely to have only a temporary effect on inflation in such circumstances. when inflation expectations are well anchored, the

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