dynamic aggregate model

Question 1

what is an SAS curve?

Answer 1

the SAS curve indicates the aggregate output that firms are willing to produce at different inflation rates

Question 2

what is the equation for the SAS curve?

Answer 2

inflation = expected inflation + a( Y - Y*) where Y is the normal output and Y is output

Question 3

what affects the level of output firms are willing to supply?

Answer 3

the normal output and the unexpected inflation

Question 4

what occurs to the SAS cruve when the expected inflation increases?

Answer 4

the SAS curve shifts up as the expected inflation increases

Question 5

what occurs to the SAS curve when the normal output increases?

Answer 5

the SAS curve shifts to the right as the normal output increases

Question 6

what is the equation for the dynamic demand curve under a flexible exchange rate?

Answer 6

inflation = money growth rate - bY + bY(-1) + h(change in world interest rate + change in expected depreciation )

Question 7

what is the purpose of having the change in the world interest rate in the dynamic demand curve ?

Answer 7

the presence of it takes care of the dependence of the world economy

Question 8

what is the purpose of having the expected depreciation in the DAD curve?

Answer 8

we take it as an exogenous variable that reflects the market psychology that is what happens if investors lose confidence in a currency for no obvious reason

Question 9

what is the equation for the dynamic demand curve under fixed exchange rates?

Answer 9

the inflation = devaluation + world inflation - bY + bY(-1) + y(change in Y world) + z(change in G) -f( change in world interest rate + expected depreciation)

Question 10

what occurs to the DAD curve under a flexible exchange rate when there is an increase in money growth, interest rate or expected depreciation?

Answer 10

the curve shifts up

Question 11

what occurs to the DAD curve under a fixed exchange rate when the world inflation or change in government spending or world income accelerates?

Answer 11

the DAD curve shifts upwards

Question 12

what occurs to the DAD curve under a fixed exchange rate when the change in the world interest rate or expected depreciation accelerates?

Answer 12

the DAD curve shifts downwards

Question 13

what are the two factors that make the DAD-SAS model inherently dynamic?

Answer 13

the first factor is that the DAD curve moves over time as income cahnages since its position is endogenously determined by last periods income. the second facto is that the position of the SAS curve depends on the expected inflation and this may be wrong so may change over time in response to actual inflation and hence shift the position of the SAS curve

Question 14

what is the long run equillibrium in the SAS_DAD model for flexible exchange rates?

Answer 14

in the long run all adjustments have petered out and individuals make no more mistakes. this means that the equilibrium aggregate supply is Y=Y. so this means in equilibrium, the aggregate supply is a vertical line through the normal output Y.
under flexible exchange rates the equilibrium aggregate demand is equal to inflation = money supply growth. this means the EAD curve is a horizontal line. the intersection between EAD and EAS determines the inflationary equilibrium in which money growth determines inflation and output is at Y*

Question 15

what is the long run equillibrium in the SAS_DAD model for fixed exchange rates?

Answer 15

in the long run all adjustments have petered out and individuals make no more mistakes. this means that the equilibrium aggregate supply is Y=Y. so this means in equilibrium, the aggregate supply is a vertical line through the normal output Y. under fixed exchange rates (letting change in G = change in world income = change in i world = 0), the EAD curve is inflation equals world inflation. so the EAD curve is a horizontal line, the intersection of EAD and EAS determines the inflationary equilibrium in which the world inflation determines inflation and output is at Y*.

Question 16

how do you position the SAS curve?

Answer 16

We know from equation (8.2) that if inflation were exactly as expected ( inflation = expected inflation ), output would be at its normal level ( Y = Y *). Therefore mark expected inflation on the vertical axis. Then go horizontally to the right until you hit the vertical line over Y *. This is a point on the current SAS curve! Now simply draw the curve with a positive slope through this point.

Question 17

how do you postion the DAD curve under flexible exchange rates?

Answer 17

under flexible exchange rates, if income remained where it was last period, inflation would equal the growth rate of the money supply (since inflation - money growth rate = -b (Y- Y(-1)). therefore mark last periods income on the horizontal axis. move vertically up until you hit the horizontal line (EAD curve) at the money growth rate. this gives you a point on the current DAD curve and you draw the curve through this point

Question 18

how do you postion the DAD curve under fixed exchange rates?

Answer 18

under fixed exchange rates, if incomes remained where it was last period, inflation would equal world inflation (since inflation - world inflation = -b ( Y -Y(-1)) ), holding other factors constant. therefore mark last periods income on the horizontal axis, move vertically up until you hit the horizontal line (EAD curve) at the world inflation + devaluation point. this gives you a point on the current DAD curve and you draw the curve through this point

Question 19

what are adaptive expectations?

Answer 19

adaptive expectations are being formed on the basis of what the variable actually did in the past. adapatice expectations are driven by the equation expected inflation [ expected inflation(-1) + a( inflation(-1) - expected inflation(-1)) . a is how quickly expectations adapt to actual inflation and is called the adjustment coefficient

Question 20

what is the one big advantage of adaptive expectations?

Answer 20

they are simple and easy to compute. they can also be quite accurate if the variable to be forecast does not change very often

Question 21

what is the simplest form of adaptive expectations for inflation

Answer 21

the expected inflation is the same as last periods inflation

Question 22

what are rational expectations?

Answer 22

rational expectations draw on all avalitable information. this may include a wide set of other variables or even knowledge of a macroeconomic model such as DAD-SAS

Question 23

what is perfect foresight mean?

Answer 23

perfect foresight is never wrong. it assumes that individuals know and foresee everything, taking the concept of rational expectations to the extreme

Question 24

what are economically rational expectations?

Answer 24

they suppose that individuals collect information and increase the sophistication of their forecasts only to the point where the costs begin to exceed the expected benefits

Question 25

what can ratoional expectations not foresee?

Answer 25

it does not work if the macroeconomic models do not explain the policy changes. policy changes usually come as surprises even for individuals who form rational expectations

Question 26

how does monetary policy affect the DAD-SAS model when there are adaptive expectations?

Answer 26

assume the economy is origninally in inflationary equilibrium at inflation* and Y*. in period 1 the central bank raises the growth rate of the nominal money supply. as money grows daster than prices the real money supply increases shifting the original DAD curve to the right. as there are adaptive expectations, the nominal wages were set before period 1 was entered based on inflation expectations of the previous period. therefore the SAS was already predetermined. as a result the equilibrium in period 1 is given by the intersection of DAD1 and SAS0. the new equilibrium in period 1 is inflation 1 and Y1. the labour markets will now revise their plans as they expect inflation to be at inflation 1 in period 2 which moves aggregate supply curve to SAS2. if the real money supply remains unchanged, income could remain at Y1 which moves the curve position to DAD2 so equilibrium in period 2 is inflation2 and Y2. this continues for future periods 3,4,5 and so on.
the general lesson to be learnt is if inflation expectations adjust slowly, a permanent increase in money growth raises income for some time above its normal level. as inflation catches up with money growth and temporarily exceeds it , income eases back towards its normal level.

Question 27

demonstrate the short run response in DAD-SAS and IS-LM-FE representation for monetary policy?

Answer 27

assume the intial equillibrium is non inflationary. in period 2 the money supply increases by 10 % so nominal money supply rises by 10%. when prices are fixed this means that real money supply also increases by 10%. this will shift the LM curve to the right. if the prices really did not respond then the excahne rate would depreciate just enough to shift the IS right , raising the income. however this is not possible as the SAS curve is not horizontal but positive slope. as a result the labour market is not prepared to supply output at unchanged prices but only when prices rise and real wages fall will output increase along SAS1. the increase in inflation will nibble away at the money supply increase shifting the LM curve back partly . at the saem time inflation reduces the exchange rate shifting IS back partly . this will lead to the actual response in period 1 will be an increased income but not as much as the fixed price response would have been.

Question 28

demonstrate the long run repsonse in DAD-SAS and IS-LM-FE representation for monetary policy?

Answer 28

in the new equillibrium, the movements of the LM and IS that occurred during the transition of the short run has ended. the real money supply which determines the position of the LM remains constant meaning the money and prices grow at the same rates. the real exchange rate which determines the position of the IS must be constant as well meaning the depreciation is equal to the inflation. so assuming the inflation, depreciation and the money growth rate are all 10%. if the currency depreciates 10% every period then sooner or later the financial investors will only be prepared to hold domestic bonds if they carry interest rates at 10% or higher than the world interest rate as compensation. this means that the new position of the FE curve is at i world +10 which identifies the new long run equilibrium. the LM and IS curve also passes through the new FE curve which provides new insights. the LM has shifted IP compared with where it was in the original equilibrium so the real money supply has fallen. so during the transition the price changes must of been greater then sum of changes in money supply. the second observation is the interest rate which determines the investment decisions is the real interest rate. as the nominal interest rate must increase to attract investors so the IS curve shifts out

Question 29

what is the real interest rate?

Answer 29

it is the nominal interest rate as observed in the market minus the inflation rate. it deducts from the nominal interest payments the purchasing power lost due to price increases.

Question 30

what is the fisher equation for the EAS?

Answer 30

it says that the interest rates change if either the real interest rate or inflation changes. the implication is that a one percent increase in inflation raises the nominal interest rate by one percent is call the fisher effect.
i = r + inflation. this only holds for equilibrium on EAS. during booms the interest rate falls below the equilibrium and recessions it rises above. this is due to firms and banks not knowing the inflation when they agree on interest rate for a loan, but base it on inflation expectations.

Question 31

what is the rational expectaion of next periods inflation given by for the DAD_SAS model?

Answer 31

it is given by the point of intersection between the EAS curve and the DAD curve anticipated for the next period

Question 32

how does fiscal policy affect the DAD-SAS model under adaptive expectations?

Answer 32

assume the econommy is in intial equillibrium where inflation is determined by the world inflation rate. this is because the commitment to a fixed exchange rate forces the central bank to let the home money supply grow at the rate of world inflation. raising government expenditure will shift the DAD curve to the right. since this comes unexpectedly, the economy moves up an unchanged SAS curve experiencing a boost in income and some inflation. the experienced inflation is expected to prevail next period. this shifts the aggregate supply curve up to SAS2. a the same time the aggregate demand curve shifts back down to DAD2 because government expenditure does not rise any further so change in government spending is equal to zero. so the effect is that inflation continues to rise when income falls. in period 3 inflation begins to recede and income falls further below its normal level. in time, inflation eases back to its original level and so does income. the details of the adjustment process depends on specific parameters constellations. the big picture is that a one time increase in expenditure increase stimualtes income and kindles inflation. both these effects are short lived however and are followed by falling inflation and even a temporary recession.