3. Dynamic AD-AS model

Question 1

What are the 3 equations which make up the dynamic AD-AS model?

Answer 1

• aggregate demand relation
• phillips curve
• Okun’s law

Question 2

What is the phillips curve?

Answer 2

It shows the relationship of inflation to unemployment. It is the aggregate supply function but written in terms of inflation, expected inflation and unemployment

Question 3

According to the phillips curve how does an increase in expected inflation influence inflation

Answer 3

If expected inflation increases so does actual inflation

Question 4

In the phillips curve what effect does increasing the mark up or increasing wage determination factors have?

Answer 4

It increases inflation

Question 5

In the phillips curve what effect does an increase in unemployment rate have?

Answer 5

Decreases inflation

Question 6

Phillips curve version 1

Answer 6

Static expectations, unemployment and inflation are negatively correlated

Question 7

Phillips curve 2

Answer 7

There appears to be no relationship between inflation and unemployment

Question 8

What are the reasons for the relationship between unemployment and inflation falling apart?

Answer 8

An increase in oil prices

A change in the way wage setters formed expectations due to a change in the behaviour of the rate of inflation

Question 9

Natural rate of unemployment

Answer 9

An unemployment rate such that the inflation rate is equal to the expected inflation rate

Question 10

Non accelerating inflation rate of unemployment (NAIRU)

Answer 10

The rate of unemployment required to keep the inflation rate constant

Question 11

What is phillips curve version 3?

Answer 11

Consumers have rational expectations so their expected inflation is the actual inflation. There is no trade off between inflation and unemployment

Question 12

What does phillips curve version 3 look like graphically?

Answer 12

Vertical line at the natural rate of unemployment

Question 13

How do different expectations for the phillips curve effect policy implications?

Answer 13

For rational expectations monetary policy is bever effective since we are always on MR equilibrium. For adaptive expectations monetary policy may temporarily affect the unemployment rate

Question 14

What is Okun’s law

Answer 14

It is a relation between unemployment and growth

Question 15

What is needed for unemployment to remain constant?

Answer 15

Output must grow by 3% per year( gyt=gy)

Question 16

Why does output growth 1% below normal lead to only 0.4% rise in unemployment?

Answer 16

• labour hoarding: firms prefer to keep workers rather than lay them off when output decreases
• when employment increases, not all new jobs are filled with unemployed, they could go to those outside the labour force

Question 17

How are growth rate of output, nominal money stock and inflation related?

Answer 17

Gyt=Gmt-inflation

Growth rate of output equals growth rate of the nominal money stock minus inflation

Question 18

If nominal money is growing faster than inflation what is happening?

Answer 18

The real money growth is rising

Question 19

How does a monetary expansion effect output?

Answer 19

Increases in SR, no effect in MR

Question 20

When in monetary policy inflationary in MR?

Answer 20

When the monetary policy is permanent

Question 21

A supply shock increases the natural rate of unemployment. what happens to growth rate of output, inflation, snd unemployment in SR and MR

Answer 21

• inflation ^SR -MR
• unemployment ^SR ^MR
• growth rate of output down in SR -MR

Question 22

How do demand shocks and supply shocks differ?

Answer 22

Demand shocks- decline in growth of output is made up for in MR.
Supply shocks- the output growth is never made up for

Question 23

Real interest rates

Answer 23

Expressed in terms of a basket of goods

Question 24

Nominal interest rates

Answer 24

Expressed in terms of pounds

Question 25

In MR what are real interest rates determined by?

Answer 25

Saving and investment opportunities

Question 26

How does high money growth affect interest rates?

Answer 26

Lower in SR, higher in MR

Question 27

Fisher effect

Answer 27

A change in growth rate of money supply leads to a one for one increase in nominal interest rates and inflation

Question 28

Effects of fiscal policy on dynamic AD-AS model

Answer 28

• in MR output growth and unemployment return to natural rate
• interest rates increase
• level of I has fallen compared to G

Question 29

Limitations of dynamic AD-AS model

Answer 29

• difficult to use
• effects of policy depend on slopes of IS and LM
• sensitive to assumption about form of expectations in the labour market
• consumption depends only on current disposable income
• closed economy model