13 Stabilisation Policy and the AS/AD Framework Flashcards
What are the three basic equations the short-run model consists of?

What is the essential trade-off of the model?
High short-run output leads to an increase in inflation. By choosing R, the bank effectively chooses how to make this trade-off.
What is the monetary policy rule equation?

What is the meaning of m (bar) in the monetary policy rule equation?
If inflation is 1 percentage point higher than the target, the rule indicates that the real interest rate should be raised above the marginal product of capital by m (bar) percentage points
Derive the AD curve equation
- Replace the MP curve with the monetary policy rule.
- Combine this rule with the IS curve
- Substitute for the Rt - r (bar) term in the IS curve with the rule itself (which says this interest rate gap depends on inflation).

AD curve diagram

Impact on AD of a shock that raises the inflation rate (diagram)

Impact of a high m (bar) on AD
+ diagram
A high value of m (bar) → sharp increase in interest rate, if inflation rises → deep recession.

Derive the AS curve equation

AS curve diagram

How do we solve for steady-state through AS-AD?

AS-AD diagram for steady state

Why does AD slope downwards?
Due to the response of policymakers to inflation.
High inflation → high interest rates → reduces investment demand → reduces output. By slowing the economy, policymakers know that it will eventually bring inflation back down.
Why does AS slope upwards?
Due to firms’ price-setting behaviour embodied in the Phillips curve.
Actual output > potential → firms struggle to meed with demand → firms raise prices → inflation increases.
What element of the framework would a sudden increase in oil prices affect and what parameters?
Impacts AS, represented as o (bar).
Initial impact + diagram of a sudden increase in oil prices

Subsequent impacts of a sudden increase in oil prices
Follows transition dynamics back to steady-state

Suppose policymakers want to reduce the inflation rate.
What element of the framework would this affect and what parameters?
Impacts AD, the only equation which includes π (bar).
Policymakers want to reduce the inflation rate.
Initial impact + diagram

Suppose policymakers want to reduce the inflation rate.
Subsequent impact + diagram
Suppose an increase in demand, or discovery of a new technology.
What element of the framework would this affect and what parameters?
Impacts AD, a temporary increase in a (bar).
Suppose an increase in demand, or discovery of a new technology.
Initial impact + diagram

Suppose an increase in demand, or discovery of a new technology.
Secondary impacts + diagram

Suppose an increase in demand, or discovery of a new technology.
Third impacts + diagram




