13 Stabilisation Policy and the AS/AD Framework

Question 1

What are the three basic equations the short-run model consists of?

Answer 1

Question 2

What is the essential trade-off of the model?

Answer 2

High short-run output leads to an increase in inflation. By choosing R, the bank effectively chooses how to make this trade-off.

Question 3

What is the monetary policy rule equation?

Answer 3

Question 4

What is the meaning of m (bar) in the monetary policy rule equation?

Answer 4

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

Question 5

Derive the AD curve equation

Answer 5

1. Replace the MP curve with the monetary policy rule.
2. Combine this rule with the IS curve
3. Substitute for the R_t - r (bar) term in the IS curve with the rule itself (which says this interest rate gap depends on inflation).

Question 6

AD curve diagram

Answer 6

Question 7

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

Answer 7

Question 8

Impact of a high m (bar) on AD

+ diagram

Answer 8

A high value of m (bar) → sharp increase in interest rate, if inflation rises → deep recession.

Question 9

Derive the AS curve equation

Answer 9

Question 10

AS curve diagram

Answer 10

Question 11

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

Answer 11

Question 12

AS-AD diagram for steady state

Answer 12

Question 13

Why does AD slope downwards?

Answer 13

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.

Question 14

Why does AS slope upwards?

Answer 14

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.

Question 15

What element of the framework would a sudden increase in oil prices affect and what parameters?

Answer 15

Impacts AS, represented as o (bar).

Question 16

Initial impact + diagram of a sudden increase in oil prices

Answer 16

Question 17

Subsequent impacts of a sudden increase in oil prices

Answer 17

Follows transition dynamics back to steady-state

Question 18

Suppose policymakers want to reduce the inflation rate.

What element of the framework would this affect and what parameters?

Answer 18

Impacts AD, the only equation which includes π (bar).

Question 19

Policymakers want to reduce the inflation rate.

Initial impact + diagram

Answer 19

Question 20

Suppose policymakers want to reduce the inflation rate.

Subsequent impact + diagram

Question 21

Suppose an increase in demand, or discovery of a new technology.

What element of the framework would this affect and what parameters?

Answer 21

Impacts AD, a temporary increase in a (bar).

Question 22

Suppose an increase in demand, or discovery of a new technology.

Initial impact + diagram

Answer 22

Question 23

Suppose an increase in demand, or discovery of a new technology.

Secondary impacts + diagram

Answer 23

Question 24

Suppose an increase in demand, or discovery of a new technology.

Third impacts + diagram

Answer 24

Question 25

Suppose an increase in demand, or discovery of a new technology.

Diagram for the full picture.

Answer 25

Question 26

How can we predict interest rates?

Answer 26

Question 27

What is the paradox of monetary policy?

Answer 27

Question 28

Concept of rational expectations

Answer 28

Under rational expectations, people make decisions based on all information available to them, including the central bank’s target rate π (bar).

Credible monetary policy → target rate contributes to expected rate.

Question 29

What would happen if the target inflation rate was to fall?

(incorporating expectations)

Answer 29