3. Dynamic AD-AS model Flashcards
What are the 3 equations which make up the dynamic AD-AS model?
- aggregate demand relation
- phillips curve
- Okun’s law
What is the phillips curve?
It shows the relationship of inflation to unemployment. It is the aggregate supply function but written in terms of inflation, expected inflation and unemployment
According to the phillips curve how does an increase in expected inflation influence inflation
If expected inflation increases so does actual inflation
In the phillips curve what effect does increasing the mark up or increasing wage determination factors have?
It increases inflation
In the phillips curve what effect does an increase in unemployment rate have?
Decreases inflation
Phillips curve version 1
Static expectations, unemployment and inflation are negatively correlated
Phillips curve 2
There appears to be no relationship between inflation and unemployment
What are the reasons for the relationship between unemployment and inflation falling apart?
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
Natural rate of unemployment
An unemployment rate such that the inflation rate is equal to the expected inflation rate
Non accelerating inflation rate of unemployment (NAIRU)
The rate of unemployment required to keep the inflation rate constant
What is phillips curve version 3?
Consumers have rational expectations so their expected inflation is the actual inflation. There is no trade off between inflation and unemployment
What does phillips curve version 3 look like graphically?
Vertical line at the natural rate of unemployment
How do different expectations for the phillips curve effect policy implications?
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
What is Okun’s law
It is a relation between unemployment and growth
What is needed for unemployment to remain constant?
Output must grow by 3% per year( gyt=gy)
Why does output growth 1% below normal lead to only 0.4% rise in unemployment?
- 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
How are growth rate of output, nominal money stock and inflation related?
Gyt=Gmt-inflation
Growth rate of output equals growth rate of the nominal money stock minus inflation
If nominal money is growing faster than inflation what is happening?
The real money growth is rising
How does a monetary expansion effect output?
Increases in SR, no effect in MR
When in monetary policy inflationary in MR?
When the monetary policy is permanent
A supply shock increases the natural rate of unemployment. what happens to growth rate of output, inflation, snd unemployment in SR and MR
- inflation ^SR -MR
- unemployment ^SR ^MR
- growth rate of output down in SR -MR
How do demand shocks and supply shocks differ?
Demand shocks- decline in growth of output is made up for in MR.
Supply shocks- the output growth is never made up for
Real interest rates
Expressed in terms of a basket of goods
Nominal interest rates
Expressed in terms of pounds
In MR what are real interest rates determined by?
Saving and investment opportunities
How does high money growth affect interest rates?
Lower in SR, higher in MR
Fisher effect
A change in growth rate of money supply leads to a one for one increase in nominal interest rates and inflation
Effects of fiscal policy on dynamic AD-AS model
- in MR output growth and unemployment return to natural rate
- interest rates increase
- level of I has fallen compared to G
Limitations of dynamic AD-AS model
- 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
