In this framework, a macroeconomic shock moves projected inflation off target and the central bank adjusts interest rates in a manner that brings inflation back to target over the next six-to-eight quarters. For ease of exposition, assume a negative shock to foreign demand, prompting the central bank to cut interest rates to keep inflation on target.
The interest rate response of the central bank works mainly through intertemporal substitution by both consumers and firms, who borrow more and spend more on goods, housing and investments. Meanwhile, the cut in interest rates is associated with some depreciation in the domestic currency, which boosts exports and dampens imports, broadening the policy effect on aggregate demand.