AD-AS

Question 1

What is the AD curve in the Keynesian model?

Answer 1

To endogenise π, note that from an IS-MP model with the Taylor rule a fall in π leads to lower r by the MP curve which raises Y, giving an inverse relationship between Y and π, drawn as a downward sloping curve in (Y, π) space

Question 2

When could the logic of an individual demand curve extend to the aggregate economy?

Answer 2

If there is a Pigou effect where consumption depends on the supply of real money balances in addition to disposable income

Question 3

What are the two ways to get an AD curve?

Answer 3

To get a (Y, π) curve the Taylor rule can be used to show a relationship between R and π
To get a (Y, P) curve use the IS-LM model to find that higher P with fixed M reduces the supply of real money balances which raises eqm r for all Y, shifting LM up which reduces Y

Question 4

What can shift the AD curve?

Answer 4

Anything that affects the IS-MP eqm
Shifts to underlying expenditure components like C̄ and G shift the AD curve by the same amount in the same direction as they shift the IS-MP eqm
Changes to policy rule parameters, particularly r̄

Question 5

What can change the slope of the AD curve?

Answer 5

Response of R to π: higher m_π leads to larger change in r for small change in π so AD is flatter
Responsiveness of Y to shift in MP: flatter IS => flatter AD, larger m_Y => steeper AD

Question 6

What is the primitive supply curve which gives eqm Y*?

Answer 6

A horizontal line in (Y, π) space at some exogenous π

Question 7

How does the ZLB affect the AD curve?

Answer 7

ZLB implies a lower limit on r which implies an upper limit to Y, denoted Ỹ = 1/(1-c) (C̄ - cT + I(-π^e) + G), so there is a kink in the demand curve where it goes vertically downward at Ỹ
If expected inflation changes, the location of the kink changes accordingly (lower expectations => lower maximum Y)

Question 8

What is the general form of the Keynesian AS curve?

Answer 8

π = π^e + v(Y - Ȳ)
This is the same relationship as the Phillips Curve

Question 9

What are the three justifications for the Keynesian AS curve?

Answer 9

Sticky prices, sticky wages, and imperfect information

Question 10

How sticky are prices empirically?

Answer 10

Excluding sales, there is significant stability, with adjustment on avg every 8-11 months

Question 11

How do sticky prices lead to an AS relationship?

Answer 11

If some fixed proportion s of firms have fixed prices so (1 - s) of firms have flexible prices, the aggregate (log) price level P = sp_s + (1 - s)p_f
Firms want to set (log) prices p = P + a(Y - Ȳ) with a > 0 (output gap relates to marginal costs) so p_f = p and p_s = p_e which assuming sticky-price firms expect no output gap gives p_s = P_e which gives a (Y, P) relationship P = P_e + a(1-s)/s (Y - Ȳ) which, when subtracting P_-1 from both sides and using log rules, gives the (Y, π) AS relationship with v = a(1-s)/s

Question 12

How do sticky wages lead to an AS relationship?

Answer 12

Assuming workers bargain for a nominal wage while firms care about a real wage, unexpected inflation reduces the real wage so firms use cheap labour to expand production
Workers bargain to W = ωP_e where ω is the target real wage consistent with Classical eqm, real wage is this over P so higher P leads to lower wage
A firm with a Cobb-Douglas production function hires labour until the real wage equals MPL which can be solved to get employment as a function of prices
If Ȳ is the output when P = P_e then Y = Ȳ(P/P_e)^{(1 - α)/α, then taking the log of this and subtracting P_-1 gives the AS relation with v = α/(1 - α)}

Question 13

How does imperfect information lead to an AS relationship?

Answer 13

Prices give producers information about nominal value but not real value as the producer doesn’t know whether a change in price was the result of a change in real value or price level
Producers will have formed some expectations of the price their product should sell for p_e and the quantity that should be sold at this price y_e, so p > p_e with some probability could be increase in valuation or fall in value of money, former means production should increase but latter means production shouldn’t change, in aggregate this leads to Y = Ȳ + α(P - P_e) which can be rearranged to get AS

Question 14

What are some critiques of the different stories for the AS relationship?

Answer 14

It is not obvious that there should be rigidity in wages or prices (workers willing to move off their labour supply curves and firms willing to produce where MR < MC)
Sticky wage story suggest real wage should be counter-cyclical but the opposite is the case
There is now much more information available so imperfect information story seems less plausible

Question 15

What do extreme values of v do to AS?

Answer 15

From π = π^e + v(Y - Ȳ), it can be seen that v = 0 is the exogenous inflation expectations model, corresponding to all firms having sticky prices or perfectly labour demand or zero probability of the price level deviating from the expected value
From Y = Ȳ + 1/v (π - π^e) it can be seen that as v approaches infinity we have the classical model, corresponding to no sticky prices or labour irrelevant to production or zero probability of relative price changing (vertical SRAS coinciding with LRAS)
In general, lower v leaves more scope for SR output volatility

Question 16

How can AS shocks be modelled?

Answer 16

π = π^e + v(Y - Ȳ) + ε means that inflation can differ from expectations even without an output gap (cost push shock)
Such a shock shifts SRAS up

Question 17

How can inflation expectations be modelled?

Answer 17

As an exogenous constant, implying a permanent inflation-output trade-off (LRAS meaningless)
As an adaptive value which can be shocked so the AS curve is π = π_-1 + v(Y - Ȳ) + ε so whenever there is an output gap the SRAS will gradually shift to restore LR output, meaning the inflation-output tradeoff is temporary, unless CB tries to fix Y > Ȳ (AD vertical to right of Ȳ) in which case inflation would increase forever
As a result of rational expectations so a permanent positive output gap is not possible but credible disinflation is easy as the policymaker just changes the inflation target and SRAS shifts immediately, and AD will change accordingly to maintain LR output

Question 18

What is the effect of government stimulus in the AS-AD model?

Answer 18

IS shifts outward by ΔG/(1-c) so for each π Y increases by ΔY < ΔG/(1-c) which means AD shifts outward by the same Δ so in SR there is positive output gap and higher inflation but output gap will be smaller than multiplied stimulus because of policy feedback on Y and upward sloping SRAS but then expectations change so SRAS shifts to restore LR output
This means there is a SR stimulus to output but at the cost of higher inflation in the SR and LR, unless CB increases r̄ in line with new classical S = I(r) which shifts MP up for all π which shifts adjusts AD so that the previous equilibrium can be attained, which in theory could happen immediately so that AD never moves

Question 19

What is the effect of a supply shock in the AS-AD model?

Answer 19

SRAS shifts up so output contracts and inflation rises but π’ < π^e + ε because of movement along AD, eventually adaptive expectations will restore previous eqm
Immediate restoration is impossible whatever the CB does to AD

Question 20

What is the implication of the ZLB for the AS-AD model?

Answer 20

If the upper bound Ỹ > Ȳ there is no impact unless there are shocks but if Ỹ < Ȳ there could be inflation below expectations which would lead to a deflation trap or deflationary spiral, potentially requiring fiscal stimulus or unconventional monetary policy to shift IS