AS/AD Framework Flashcards
Policy Rule:
Rt - r̅ = m̅(πt - π̅)
Why is the policy rule considered “closed loop”
Rt →Ỹ → π → Rt - 1 endogenous variable is determined by another
AD Curve:
Ỹt = a̅ - b̅m̅(πt - π̅)
How does the AD curve function?
If the central bank sees an inflation rate higher than its target π̅, the monetary policy rule dictates an increase in interest rates. The higher interest rates cause a reduction in I and a slowdown in economic activity - a movement along the AD curve
What does m̅ describe?
willingness of the central bank to incite a recession/boom to combat inflation - the steepness of AD - high m̅ = flat (more ΔỸ), low m̅ = steep
What is compared in the AD/AS diagram?
π vs Ỹ NOT Δπ
What can shift the AD curve?
a̅ - temporary, π̅ - permanent
AS Curve:
πt = πte + v̅Ỹt + o̅t
What is the Stabilisation Problem associated with the AS/AD framework?
In the IS-MP model, it is possible to adjust R to keep Ỹ at potential, so there is no reason to go through the cycle.
The problem arises because the monetary policy rule responds only to inflation and not to changes in output.
The length of time it takes to ascertain whether a shock is a boom or a bust further complicates policy
Policy Rule + Fisher equation =
it = r̅ + πt + m̅(πt - π̅)
What is the Taylor Rule?
Taylor rule describes on average how central banks conduct MP. Has morphed from descriptive to prescriptive
Taylor Rule Parameters:
m̅ = 1/2 r̅ = 2% π̅ = 2%
How long ahead do central banks forecast inflation and why?
Central bank tries to forecasts inflation 1-2 years in the future because of the MP lag
What is Rational Expectations?
People use all information at their disposal to make their best forecast of the coming rate of inflation. people do not make systematic errors, they take all available information - people look to the long run
R.E. + credible CB + o̅ =
If firms know that the CB will fight aggressively to keep inflation at a low rate no matter the consequences, then they are much less likely to raise prices sharply in response to an inflation shock.
What can affect short run output under R.E.?
It is only surprises that can affect Ỹ - i.e. + o̅
What is the Policy Ineffectiveness Proposition?
The government is unable to incite any output changes under R.E. as following any increase in G (AS curve shift) or tax changes as AD will shift immediately so short run output remains at potential
What conditions are necessary for the Policy Ineffectiveness Proposition?
R.E. & fluid prices
How can Central Banks control inflationary expectations?
Announce an explicit monetary policy rule or adopt an explicit target inflation rate for the medium horizon
An explicit inflation target make it easier for the central bank to stabilise output?
Possibly, when the central bank eases monetary policy to stimulate the economy, if firms and workers understand the commitment to the target inflation rate, they won’t be tempted to deviate from their standard price setting behaviour and this will allow the monetary stimulus to exert its desired short term effect of output
What does R.E. incentivise the Central Bank to do?
Under R.E. There is in principle an incentive for governments to control expectations in a way such that they can surprise the public - the only policy that matters (affects output) is the policy that isn’t anticipated
What does coordination of inflationary expectations require?
Credibility and transparency on the part of the central bank
What is constrained discretion?
The idea that a central bank has the flexibility to respond to shocks in the short run, but remain committed to a particular target inflation rate in the long run
What is the Real Business Cycle?
Assumes R.E. - i.e. AD can’t affect Ỹ substantially
Assumes the classical dichotomy in both long and short run
Everything including cycles is determined by the real side
Cycle is caused by factors that affect Y̅
- Fluctuations are driven by real forces
- Savings rate, Investment rate, TFP, - productivity changes
Against stabilisation policies
What is the New-Keynesian Business Cycle?
Fluctuations the result of AS & AD, although actual output can be
affected by Y̅ as well
Possibly driven by “animal spirits” i.e. optimism or pessimism
Shocks are often propagated due to rigidities in the economy
Pro stabilisation policies
What are the New-Keynesian Business Cycle shock propagation mechanisms?
Multipliers
Sticky prices/inflation/wages
Imperfect information
What is the Austrian Business Cycle?
Fluctuations largely the result of credit cycles (mal-investment)
Optimism → Booms → ↑I (in bad projects) → ↑Credit (in bad projects) →Defaults → Bust
.com boom
Sources of credit/debit fluctuations aren’t specified - animal spirits
Libertarian, cautious of G intervention in spite of market inefficiencies
What is the Hetrodox (Post Keynesian) theory?
Fluctuations largely the result of credit cycles (mal-investment)
Diagnosis is similar to Austrian
Prefer government intervention - scope for stabilisation
What is the Marxian BC theory?
Fluctuations largely consequence of distributive struggle between capitalists and workers
Battle between wage earners & capital earners over Y̅ share & resources
How can the right mix of MP and fiscal policy help the economy?
Help a country out of a recession
Improve the trade position without ↑Ỹ or ↑π
Slow down an overheating economy
Stimulate I & K accumulation
Case against balanced budget amendment:
Would also eliminate the use of fiscal policy as a macro policy instrument
A constitutional amendment is not the only way to achieve deficit control & reduction
Case for balanced budget amendment:
Would eliminate the problem of deficits
Lags in the legislative process prevent the government from changing fiscal policy in time to stabilise the economy
Rules that Parliament may impose on itself can be changed by a vote later on
Arguments for policy restraint:
Policy makers may have good intentions but they may end up doing more harm than good because of uncertainty and time inconsistency.
Policy makers do what’s best for them instead of the country such as with the political business cycle
How can Central Banks establish credibility?
Make the central bank independent and away from political pressure
Chose a conservative central banker who dislikes inflation
Gain a reputation e.g. of not raising interest rates in lieu of a recession
Drawing up rules for the central bank i.e. ways to commit to initial promise
What is Time Inconsistency?
An announcement is made about policy, but when time to implement comes around the optimality of following through is different
What is an example of Time Inconsistency?
After firms and workers have formed their expectations about inflation and built them into their contracts and pricing strategies, the central bank has an incentive to pursue expansionary policy to that the economy will boom
What can cause a higher v̅?
(steeper) Less sticky inflation - customers more willing to accept price changes, computerised price setting, weaker unions
What effect would weaker C or I multipliers have on the AD curve?
Would be steeper
What effect would a lower b̅ have on the AD curve?
Steeper, weaker I response to R
What effect would a lower m̅ have on the AD curve?
Steeper, CB cares less about inflation
Taylors suggestion to incorporate Ỹ into the AD curve:
Ỹ = (a̅/(1+bn)) - (bm/(1+bn)) (π - π̅)
If n = 0 then normal AD curve
b/c 1+bn > 0, new AD is steeper + more muted to a̅ shocks
A policy rule to completely offset AD shocks:
Ỹ = a̅ - a̅ → Ỹ = a̅ - b̅(a̅/b̅) → R - r̅= a̅/b̅
What is the Taylor Principle?
When π increases by 1%, CB must increase i > 1% for R to increase
π↑1% + i↑<1% → R↓ = i↑ - π↑↑
Liquidity Trap Solution:
↑Ms, buy long maturity bonds to ↓ L.T. i/r
How can the fed keep unemployment constantly low?
By increasing inflation forever - temporary trade off
