[5] Dynamics

Question 1

dynamic model of___ ___ and ___ ___ gives us more insight into how the economy works in the __ ___

Answer 1

aggregate demand
aggregate supply
short run

Question 2

The dynamic model of aggregate demand and aggregate supply is built from familiar concepts?
x3, explain briefly each

Answer 2

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

Question 3

How the dynamic AD-AS model is different from the standard model? x3, explain each

Answer 3

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.

Question 4

The model has 5 endogenous variables?

and 5 equations for each [state on next slides]

Answer 4

output, 
inflation, 
the real interest rate, 
the nominal interest rate, 
and expected inflation.

Question 5

The equation for output [endogenous variable]
What do the different variables mean?

What does it show?

Answer 5

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

Question 6

The real interest rate: The Fisher equation Equation

Answer 6

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

Question 7

Inflation: The Phillips curve Equation

Explain each variable

Okun’s Law

Answer 7

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

Question 8

Expected inflation: Adaptive expectations Equation

Assume in this model that expectations are adaptive

IN EXAM ; STATE WHETHER EXPECTATIONS ARE ADAPTIVE OR RATIONAL

Answer 8

Et πt+1 = πt

For simplicity, we assume that people expect prices to continue rising at the current inflation rate.
⌄

Question 9

Nominal Interest Rate Equation: The monetary policy rule

Explain each variable

Answer 9

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

Question 10

Name the Endogenous Variables (5), Exogenous variables (5) and the parameters (5)?

Answer 10

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

Question 11

Long-run equilibrium is the …

Two conditions required for long-run equilibrium:

Answer 11

the normal state around which the economy fluctuates.

1) There are no shocks: εt = vt =0
2) Inflation is constant: πt = πt-1

Question 12

Plugging the 2 LR equilibrium conditions into the 5 equations gives what values [5]

Answer 12

Yt = ȳt
 πt =  πt*
 Et πt+1 =  πt*
it = rN +  πt*
rt = rN

Question 13

The DAS curve shows a relationship between __and ___ that comes from the ___ ___ and ___ ___

Equation?
DAS shifts in response to changes in… x3
DAS slopes…

Answer 13

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.

Question 14

To derive the DAD curve we combine __ ___ then eliminate the ___ ___ other than ___ and ___
What equation do we start with?

Answer 14

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

Question 15

Step By Step for deriving DAD curve

Answer 15

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

Question 16

What is the final equation for DAD curve?
What do the various

What do A and B equal?

Answer 16

Yt = ȳt - A(πt - πt*) + Bεt

A= SLIDE 25
B=

Question 17

DAD slopes ___; when ___ rises, the central bank ___ ___ ___ rate, which ___ ___ goods and services

What causes DAD to shift?

Answer 17

downwards, inflation, raise real interest, reduces demand

natural level of output, demand shocks , target level of inflation (look at equation)

Question 18

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?

Answer 18

equilibrium inflation output#

SLIDE 27

Question 19

Show the effects of Long Run Growth on the DAD, DAS graph from equilibrium?
Explain the steps

Answer 19

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.

Question 20

Show the effects of Adverse Supply Shock on the DAD, DAS graph from equilibrium?
Explain the steps

How long does the process continue?

Answer 20

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

Question 21

Give estimate values for the different parameters?

What happens to different parameters following a supply shock?

Answer 21

slide 30

output fall
inflation rise
real interest rate rise

Question 22

A positive shock to aggregate demand on DAD, DAS graph? Explain the steps?

Answer 22

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

Question 23

How does a positive demand shock affect the parameters?

Answer 23

Interest rate increases
Inflation increases
output increases

Question 24

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.

Answer 24

five,
IS, fisher, Phillip’s , expected inflation, monetary policy

Classical, 
output,
 real interest rate, 
monetary policy,
 inflation target

Question 25

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.

Answer 25

shock,
over time.

parameters
DAS
output or inflation
central bank,
tradeoff