AS/AD Flashcards
Describe the monetary policy rule
- The monetary policy depends on current inflation and the inflation target. If inflation is above target; real interest rate should be high. If below; real interest rate should be low
- The m-parameter governs how aggressively monetary policy responds to inflation – how inflation is fought. The real rate should be raised/lowered above/below the MPK by m percentage points
The AD curve
The AD curve describes how the central bank sets short-run output for each different rate of inflation. If inflation is above its target, the bank raises interest rate and pushes output below potential. If inflation is below its target, the bank stimulates the economy by lowering the interest rate and pushes output above potential.
Moving along the AD curve
If the economy is hit by a shock that raises inflation above target, we will see a movement along the curve. The m parameter governs how aggressively monetary policy responds to inflation and alters the slope of the curve. A high m value will prescribe a sharp increase in interest rate if inflation rises, leading to a deep recession -> flat curve.
Shifts of the AD curve
Changes in aggregate demand and target of inflation shift the curve and change the level of short-run output that the central bank desires at any given inflation rate.
The AS curve
The price-setting equation used by firms in the economy:
Just as the Phillips curve shows; a higher output gap leads firms to raise prices resulting in higher rate of inflation today. When no inflation shocks and when output is at potential, firms simply expect the current rate of inflation to continue.
Steady state of the AS/AD framework
The steady state of the model is the point where inflation rate is equal to the central bank’s target and actual output is at potential.
Why does the AD curve slope downward?
Because of the response of the policymakers to inflation. When the inflation rate is higher than the inflation target, monetary policy rule implies that the real interest should increase. When the interest rate increases, borrowing becomes more expensive and investment decreases. The decrease will result in a negative output gap which eventually will lower the inflation. Negative relation between output and inflation.
Why does the AS curve slope upward?
The AS curve slopes upward as an implication of the price-setting behavior of firms embodied in the Phillips curve. When actual output exceeds potential, firms will raise prices more than usual as a response to higher demand and costs. This behavior will increase the rate of inflation. Positive relation between output and inflation.
Describe the implications of macroeconomic events in the framework
- Inflation shock
- Disinflation - lower inflation target
- Aggregate demand shock
The paradox of policy and rational expectations
The ultimate goal is full employment, output at potential and low, stable inflation. The great paradox of monetary policy is that the best way a central bank can achieve this goal may be to focus on maintain low inflation and to show willingness to engineer large recessions. Why don’t expectations on inflation depends on the central banks inflation target, rather than the last periods inflation? The motivation for this assumption is the stickiness of inflation. But we can consider another benchmark: rational expectations.
Rational expectations
Under rational expectations, people use all information at their disposal to make their best forecast of the coming rate of inflation. This information may include the costs that tend to make inflation sticky. But it may also include the central bank’s target rate of inflation and any announcements the bank may make about its future target. This means that if a credible central bank changes its policy rule, expected inflation may adjust directly.
To the extent that the central bank can coordinate people’s expectations of inflation, it can maintain a low and stable inflation without the need for recessions.
Lucas critique
The Lucas critique says that its inappropriate to build a macroeconomic model based on simple assumptions about expectations, such as adaptive expectations. Robert Lucas applied the theory of rational expectations and stated that when a credible central bank announces a change in its monetary policy rule, expected inflation changes directly. Any models based on adaptive expectations could thus lead to incorrect predictions.
Inflation targeting
To improve the management of inflation expectations, central banks adopt an explicit target rate of inflation. Constrained discretion: in the short-run, the central banks has the flexibility to respond to shocks to the economy in order to ensure stability of output and inflation. Over the long-run, however, it maintains a commitment to a particular rate of inflation.
