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
Suppose an increase in demand, or discovery of a new technology.
Diagram for the full picture.
How can we predict interest rates?
What is the paradox of monetary policy?
Concept of rational expectations
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.
What would happen if the target inflation rate was to fall?
(incorporating expectations)
