[5] Dynamics Flashcards
dynamic model of___ ___ and ___ ___ gives us more insight into how the economy works in the __ ___
aggregate demand
aggregate supply
short run
The dynamic model of aggregate demand and aggregate supply is built from familiar concepts?
x3, explain briefly each
Philips Curve; which relates inflation to the gap between output and its natural level, expected inflation, and supply shocks
IS Curve; which negatively relates the real interest rate and demand for goods and services
Adaptive expectations; a simple model of inflation expectations
How the dynamic AD-AS model is different from the standard model? x3, explain each
Instead of fixing the money supply, the central bank follows a monetary policy rule that adjusts interest rates when output or inflation change.
The vertical axis of the DAD–DAS diagram measures the inflation rate, not the price level.
Subsequent time periods are linked together:Changes in inflation in one period alter expectations of future inflation, which changes aggregate supply in future periods, which further alters inflation and inflation expectations.
The model has 5 endogenous variables?
and 5 equations for each [state on next slides]
output, inflation, the real interest rate, the nominal interest rate, and expected inflation.
The equation for output [endogenous variable]
What do the different variables mean?
What does it show?
Y = ȳ - a ( rR - rN) + εt
Yt= output
Y bar = natural level of output
Alpha = (higher = more responsive output to changes form r changes
Rho= natural rate of r
Epsolon= demand shock (eg – increase in gov purchases)
Negative relationship between output and interest rate
The real interest rate: The Fisher equation Equation
rt = it + Et πt+1
rt : real IR, it : nominal interest rate
Et πt+1 : the expectation formed in period t of inflations in period t + 1
Inflation: The Phillips curve Equation
Explain each variable
Okun’s Law
πt = Et-1 πt + Φ ( Yt - ȳt) + vt
πt ; current inflation
Et-1 πt ; previously expected inflation
Φ ; how much inflation responds when output fluctuates around its natural rate
vt ; supply shock, random and zero on average
Pos output result from nega inflation deviations
Expected inflation: Adaptive expectations Equation
Assume in this model that expectations are adaptive
IN EXAM ; STATE WHETHER EXPECTATIONS ARE ADAPTIVE OR RATIONAL
Et πt+1 = πt
For simplicity, we assume that people expect prices to continue rising at the current inflation rate.
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Nominal Interest Rate Equation: The monetary policy rule
Explain each variable
it = πt + rN + θ(π) [ πt -πt* ] + θ(Y) [ yt - ȳt ]
it ; nominal interest rate in period t
rN ; natural rate of interest
[ πt -πt* ] ; central banks inflation target
θ(π) ; measures how much the central bank changes interest rate when inflation deviates from target
θ(Y) ; measures how much central bank changes interest rate when output deviates from target
Name the Endogenous Variables (5), Exogenous variables (5) and the parameters (5)?
SLIDE 16-17
α = responsiveness of demand to the real interest rate ρ = natural rate of interest
Φ= responsiveness of inflation to output in the Phillips curve
θ_π = responsiveness ofito inflationin the monetary policy rule
θ_Y = responsiveness ofito outputin the monetary policy rule
Long-run equilibrium is the …
Two conditions required for long-run equilibrium:
the normal state around which the economy fluctuates.
1) There are no shocks: εt = vt =0
2) Inflation is constant: πt = πt-1
Plugging the 2 LR equilibrium conditions into the 5 equations gives what values [5]
Yt = ȳt πt = πt* Et πt+1 = πt* it = rN + πt* rt = rN
The DAS curve shows a relationship between __and ___ that comes from the ___ ___ and ___ ___
Equation?
DAS shifts in response to changes in… x3
DAS slopes…
output , inflation
Phillips curve , adaptive expectations
πt = πt-1 + Φ ( Yt - ȳt) + vt
the natural level of output, previous inflation, and supply shocks. (look at equation)
DAS slopes upward: high levels of output are associated with high inflation.
To derive the DAD curve we combine __ ___ then eliminate the ___ ___ other than ___ and ___
What equation do we start with?
We will combine four equations and then eliminate all the endogenous variables other than output and inflation.
Start with the demand for goods and services
Step By Step for deriving DAD curve
Start with the Output/demand for Goods and services
Sub in Fisher Eq for ‘rt’
Sub in Expectations Eq for ‘Et πt+1 = πt*’
Sub in [long] Monetary Policy rule in for ‘it’ and cancel
combine like terms, solve for Y
What is the final equation for DAD curve?
What do the various
What do A and B equal?
Yt = ȳt - A(πt - πt*) + Bεt
A= SLIDE 25
B=
DAD slopes ___; when ___ rises, the central bank ___ ___ ___ rate, which ___ ___ goods and services
What causes DAD to shift?
downwards, inflation, raise real interest, reduces demand
natural level of output, demand shocks , target level of inflation (look at equation)
In each period, the intersection of DAD and DAS determines the short-run __ values of ___ and ___.
Draw the DAD and DAS in equilibrium on a graph?
equilibrium inflation output#
SLIDE 27
Show the effects of Long Run Growth on the DAD, DAS graph from equilibrium?
Explain the steps
Slide 28
Period t + 1: Long-run growth increases the natural rate of output.
DAS shifts right because economy can produce more goods and services.
DAD shifts because higher income raises demand for goods and services.
New equilibrium; income grows but inflation remains stable.
Show the effects of Adverse Supply Shock on the DAD, DAS graph from equilibrium?
Explain the steps
How long does the process continue?
Shifts DAS upward/left sharply
causing inflation to raise and inflation to fall
Eventually in later period, inflation falls
and output raises.
This process continues until output returns to its natural rate, the Long-run equilibrium
Give estimate values for the different parameters?
What happens to different parameters following a supply shock?
slide 30
output fall
inflation rise
real interest rate rise
A positive shock to aggregate demand on DAD, DAS graph? Explain the steps?
A positive shock to demand
causes output to increase and inflation to rise
In subsequent periods, higher expected inflation causes the DAS shift upward.
When the demand shock disappears, output falls and so inflation expectations fall, economy gradually recovers until reaching long-run equilibrium
How does a positive demand shock affect the parameters?
Interest rate increases
Inflation increases
output increases
SUMMARY
The DAD–DAS model combines __ relationships: an _ _-curve-like equation of the goods market, the __ equation, a __ curve equation, an equation for __ ___, and a __ ___ rule.
The long-run equilibrium of the model is ___. __ and the __ __ __ are at their natural levels, independent of __ __. The central bank’s ___ ___determines inflation, expected inflation, and the nominal interest rate.
five,
IS, fisher, Phillip’s , expected inflation, monetary policy
Classical, output, real interest rate, monetary policy, inflation target
SUMMARY
The DAD–DAS model can be used to determine the immediate impact of any ___ on the economy and can be used to trace the effects of the shock __ ___.
The __ of the monetary policy rule influence the slope of the __ curve, so they determine whether a supply shock has a greater effect on __ or ___. Thus, the ___ ___ faces a ___ between output variability and inflation variability.
shock,
over time.
parameters DAS output or inflation central bank, tradeoff
