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ECON2026 > IS/AD > Flashcards

IS/AD Flashcards

1
Q

What is planned expenditure?

A

Planned expenditure is the total amount of spending on domestically produced goods and services that households, businesses, the government and foreigners want to make (vs actual expenditure) (i.e. the amount that is produced)

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2
Q

What is AD?

A

Aggregate demand is the total amount of output demanded in the economy = YAD = C + I + G + NX = planned expenditur

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3
Q

What is IS consumption?

A
  • Income is the most important factors in determining C spending
  • Disposable income YD is total income less taxes (Y -T)
  • The marginal propensity to consume (c) is the slope of the consumption function (∆C/∆YD)
    • The change in consumer expenditure that results from an additional dollar disposable income
  • C̅: autonomous consumer expenditure: the amount of consumer expenditure that is independent of disposable income
  • C = C̅ + cYD
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4
Q

What is IS investment?

A
  • I = I̅ - drc
    • d: responsiveness of Investment
    • rc : ‘real cost of borrowing’
  • I = I̅ - d(r + f̅)
    • I increases with in increase in I̅: ‘Business Optimism’
    • I decreases with an increase in r
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5
Q

What is the firms investment decision?

A
  • Firms w/o excess funds
    • Invest if rate of return ≥rc
    • rc = r + f̅
      • r: real interest rate
      • f̅: financial frictions (asymmetric info)
  • Firms w/ excess funds
    • Invest if rate of return > rc (OC of buying securities)
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6
Q

What is IS NX?

A
  • (X-M)
  • Two componends
    • Autonomous net exports
    • Net exports affected by the real interest rate
  • NX = N̅X̅ - xx
    • x: responsiveness of NX
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7
Q

What is IS G and T?

A
  • G = G̅
  • T = T̅
  • Both exogenous
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8
Q

What is the IS curve?

A
  • Tells us the points at which the goods market is in eqm
  • Examines an equilibrium where aggregate output equals aggregate demand
  • Assumes fixed price level where nominal and real quantities are the same
  • IS curve is the relationship between eqm aggregate output and the interest rate
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9
Q

What is the IS curve formula?

A
  • Y = (A̅/(1-c) - ((d + x)/(1-c))r
  • A̅ = C̅ - cT̅ + I - df̅ + G̅ + N̅X̅
    • (A̅/(1-c): shifts in IS
    • ((d + x)/(1-c))r: movements along IS
    • Need to be most careful when working out A̅
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10
Q

Broadly, what shifts IS?

A
  • Changes in autonomous factors (i.e. ones independent of disposable income and the real interest rate)
  • Changes in Taxes
  • Changes in financial frictions
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11
Q

How do autonomous factors affect IS?

A
  • G increases: shifts IS out
  • Autonomous C increases: shifts IS out
  • Autonomous I increases: shifts IS out
  • Autonomous NX increases: shifts IS out
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12
Q

How do taxes affect IS?

A
  • At any given real interest rate, a rise in taxes causes aggregate demand and hence eqm output to fall, thereby shifting IS left
  • A tax cut at any given real interest rate raises disposable income and shifts IS right
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13
Q

How do frictions affect IS?

A
  • A rise in f̅ shifts IS in

- A fall in f̅ shifts IS OUT

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14
Q

What is the MP curve?

A
  • When the fed lowers the fed funds rate: real interest rates fall and vice versa
    • Change in i will affect r only if inflation rate is actual and expected and prices are sticky
  • Shows how monetary policy, measured by the real interest rate, reacts to the inflation rate: positive relationship
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15
Q

What is the MP curve formula?

A
  • r = r̅ + λπ
    • r̅: autonomous component of r
    • λ: responsiveness of r to inflation
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16
Q

What is the Taylor principle?

A
  • Key reason for an upward sloping MP curve is that the FED seeks to keep inflation stable
  • Principle: To stabilise inflation, CB’s must raise nominal interest rates by more than any rise in expected inflation, so that r rises when π rises
  • If CB’s allow r to fall when πrises then the lower r will boost the economy, leading to further inflation and so on
  • Automatic (Taylor principle) changes reflected by movements along the MP curve
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17
Q

What shifts the MP curve?

A
  • Autonomous changes that shift the MP curve
  • Tightening: r̅ increase: up
  • Easing: r̅ decrease: down
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18
Q

What is AD?

A

Represents the relationship between the inflation rate and aggregate demand when the goods markets is in eqm

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19
Q

What is the AD formula?

A

AD: Y = (A̅/(1-c) - ((d + x)/(1-c))(r̅ + λπ)

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20
Q

How is AD graphically derived?

A
  • From MP and IS curves
  • AD has a downward slope: as inflation rises, the real interest rate rises, so that spending and equilibrium aggregate output fall
  • MP curve links the inflation rate to the real interest rate level set by CB
  • IS curve links the real interest rate level from the MP curve to eqm output
  • AD curve links inflation from MP and eqm output
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21
Q

What is the AD curve’s rationale?

A
  • Increase in inflation increases r, which decreases I and so decreases Y
  • Increase in inflation increases r, which increases Dexports, which causes appreciation, NX falls, and so decreases Y
  • Quantity Theory of Money: If velocity is constant, a decrease in the price level is matched with an increase in Y
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22
Q

What have a positive shift on the AD curve?

A
  • Autonomous C
  • Autonomous I
  • G̅
  • Autonomous NX
  • Money Supply
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23
Q

What have a negative shift on the AD curve?

A
  • r̅
  • T̅
  • f̅
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24
Q

What MP shifts the AD curve?

A
  • An autonomous tightening of monetary policy (rise in real interest rate), shifts AD to the left
  • An autonomous easing of monetary policy (lower real interest rates), shifts AD right
  • Such such changes will immediately reflect on the IS curve
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25
Q

What is true about the AS/AD model?

A
  • Sticky price assumption for MP to be effective

- inflation expectations are they key driver

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26
Q

What is LRAS?

A
  • Determined by amount of capital and labor and the available technology: Y = f(K,L,A)
  • Vertical at the natural rate of output generated by the natural rate of unemployment
  • Assumption: In LR, we are at full employment; L is at the natural rate (frictional + structural)
    • i.e. Y value of LRAS is YP: potential output (output level when unemployment rate = natural rate)
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27
Q

What can increase LRAS?

A
  • Increase in the total amount of K
  • Increase in the total amount of L
  • Increase in A
  • Decrease natural rate of U
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28
Q

What is SRAS?

A
  • Wages and prices are sticky: Keynes: therefore inflation expectations are they key driver
  • Generates an upward sloping SRAS as firms attempt to take advantage of short run profitability when price level rises
  • Based on the idea that three factors generate π
    • Inflation expectations
    • Output Gap
    • Price/Supply Shocks
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29
Q

How does the output gap explain SRAS?

A
  • Positive
    • Y > YP is a positive output gap, and this implies tight labour markets: workers demanded higher wages
    • Firms increase prices in response: increase inflation
  • Negaitve
    • Y < YP is a positive output gap, and this implies slack labour markets: workers demanded lower wages
    • Firms decrease prices in response: decrease inflation
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30
Q

SRAS:

A
  • π = πe + ɣ(Y - YP) + 𝜌

- Current inflation = expected inaction + (sensitivity of inflation to output gap * output gap) + price shocks

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31
Q

What can shift SRAS?

A
  • πe
  • 𝜌
  • Persistent Output Gaps
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32
Q

What are persistent output gaps?

A
  • Non-persistent output gaps describe the movement along SRAS
  • Increase in (Y - YP): movement along SRAS, πrises
  • If (Y - YP)>0 persistently: affects πe: shifts SRAS, πrises
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33
Q

What is the long run AS/AD equilibrium?

A

LRAS = SRAS = AD = π* = Y* = YP

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34
Q

What happens with a positive output gap?

A
  • Y > YP = Tight labour market
  • Tight labour market: increase wages: (increase π:) increase πe: increase SRAS
    • Increases in πdo not affect SRAS! Only πe, which follows changes in π!
  • Self-Correcting Mechanism
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35
Q

What is the self-correcteing mechanism?

A
  • Regardless of where output is initially, it returns eventually to the natural rate
  • Slow
    • Wages are inflexible, paritcualry downward
    • Need for policy
  • Rapid
    • Wages and prices are flexible
    • Less need for policy
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36
Q

What effect does a positive AD shock have?

A

AD Increases: +Y Gap: Tight labour market: increase wages: increase P: increase inflation expectation: SRAS increase

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37
Q

What can cause a temporary supply shock?

A
  • Negative
    • 𝜌 increases
    • Restricts S
    • Increases P
  • Long run equilibrium remains the same
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38
Q

What are permanent supply shocks?

A
  • LRAS will shift
  • e.g. increase in bad regulations
  • Permanent supply shock: increases P: increases π: increases expected π: shifts SRAS left
  • Now have +Y gap: further shifts AS to new eqm
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39
Q

What is the RBC?

A

RBC: Real shocks to supply alone (potential GDP) generate short-run fluctuations, no role for AD: no role for MP & FP

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40
Q

What is the Phillips Curve?

A
  • Negative relationship between π and U
  • Logic: when LM is tight (U is low), firms have to raise wages to attract and keep workers
  • π = πe - ω(U - Un) + 𝜌
    - Current inflation = expected inflation - ω(unemployment gap) + price shock
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41
Q

What can shock the Phillips Curve?

A
  • Inflation (causing inflation expectations)
  • Inflation expectations on their own
  • Price shocks
42
Q

What is the LR Phillips Curve?

A
  • Vertical

- There is a SR, but not a LR trade off between U and π

43
Q

What is Okun’s Law?

A
  • Describes the negative relationship between the U gap the Y gap
  • For each % that output is above potential, the U rate is 1/2% under the natural rate
  • U - Un = 1/2(Y - Yp)
44
Q

How can SRAS be derived?

A

Okun’s Law and SRPC

45
Q

What is MP in the AD/AS?

A
  • Should try to minimise the different between inflation and the inflation target
  • In the case of both demand and permanent supply shocks, policy makers can simultaneously pursue price stability and stability in economic activity
  • Following a temporary supply shock, policy makers can achieve either price stability or economic activity stability, but not both. This poses a dilemma for CB’s with dual mandates
46
Q

What is the CB’s intervention mechanism?

A
  • CB affects AD
  • MP: r = r̅ + λπ
  • Monetary tightening
    • Increase r̅: increase r: decrease I: decrease AD
  • Monetary Easing
    • Decrease r̅: decrease r: increase I: increase AD
47
Q

What is outcome of no policy response to a negative AD shock?

A

AD shifts back: YP > Y: slack LM: wages decreases: P decreases: πdecreases: π expectations decrease: AS equalises

48
Q

What is outcome of policy to a negative AD shock?

A

AD shifts left: YP > Y: monetary easing: Decrease r̅: decrease r: increase I: increase AD

49
Q

What are the outcomes and difference between ignoring and responding a LRAS shift?

A
  • (LRAS shifts back: rises π: rises expectations: shifts AS up: Y > YP): monetary tightening: AD shifts back
  • Both responses yield the same Y, no response brings much higher π
50
Q

What is true of SRAS shocks?

A

Policy Dilemma: U or π

51
Q

What is outcome of an inflation preference response to a negative SRAS shock?

A

SRAS shifts left: Monetary tightening (AD): π stabilised, (YP > Y): slack LM: πe falls: AS shifts back: Monetary easing: (YP = Y)

52
Q

What is outcome of an output preference response to a negative SRAS shock?

A

SRAS shifts left: Monetary easing (AD): π much higher, eqm Y stabilised

53
Q

What lags are there to MP?

A
  • Data lag
  • Recognition lag
  • Legislative lag
  • Implementation lag
  • Effectiveness lag
54
Q

What are activists?

A
  • Activists see the need for the government to pursue active policies to eliminate high unemployment
  • Non-activists believe this is unnecessary
55
Q

What did Friedman say?

A
  • Inflation is always and everywhere a monetary phenomenon
  • This adage is supported by our aggregate demand and supply analysis: MP makers can target any inflation rate in the long run by shifting the aggregate demand curve with autonomous monetary policy
  • i.e. through MP, can reach two different inflation levels for the same output level
56
Q

What is cost-push inflation?

A
  • Results from either a temporary negative supply shock or a push by workers for wage hikes beyond what productive gains can justify
  • Y < YP
  • U lies above the natural rate
57
Q

What is demand-pull inflation?

A
  • Results from policy makers pursuing policies that increase aggregate demand
  • Y > YP
  • U lies below the natural rate
58
Q

What is the problem with the ZLB?

A
  • The Fed can attempt to reduce the real interest rate by lowering the federal funds rate
  • The federal funds rate, though, is stated in nominal terms, and therefore cannot fall below zero (arbitrage)
  • If fed funds rate is 0, real r may be negative
59
Q

What happens to the self correcting mechanism at the ZLB?

A
  • When Y < YP and Zero Lower Bound on the policy rate has been reached, output is not restored to its potential level if policymakers to nothing
  • In this situation the economy goes into a deflationary spiral
  • (Y < YP): slack LM: wages decreases: P decreases: πdecreases: π expectations decrease: SRAS shifts down: Spiral
  • At ZLB (short term nominal interest rate = 0), self correcting mechanism does not work
60
Q

What are the nonconventional MP options?

A
  • Liquidity provision
  • Asset purchase (quantitative easing)
  • Management of expectations
61
Q

What is the liquidity provision solution?

A
  • Bring down financial frictions by increasing its lending facilities in order to provide more liquidity to impaired markets so that they can return to their normal functions
  • This decline in financial friction lowers the real interest rate for investments
  • Shift in AD to LRAS/AS intersection
62
Q

What is the asset purchase solution?

A
  • Also lowers financial frictions, but by lowering the SR/LR credit spread by the purchase of long term private assets
  • i.e. affecting the long term interest rate through affecting the SR/LR credit spread
  • Purchase private assets: increases their price: decreases long term interest rate = f̅ decrease: AD shifts out
  • Shift in AD to LRAS/AS intersection
63
Q

What is the expectations management solution?

A
  • Forward guidance in which the central bank commits to keeping the policy rate low for a long period of time is another way of lowering long-term interest rates relative to short-term rates and thereby lowering financial frictions and the real interest rate for investment
  • This can lead to both rightward shifts in AD and shifting the SRAS by raising inflation expectations
  • rlong term = rshort term + f̅
  • CB lowers f̅ through forward guidance
64
Q

What is the Lucas critique?

A
  • Econometric models are unreliable for evaluation of policy options if they do not incorporate rational expectations
  • When policies change, public expectations shift and this can have an outcome
65
Q

What kinds of conduct are there?

A
  • Policy discretion
  • Policy rules
  • Constrained Discretion
66
Q

What is policy discretion?

A
  • Applied when policymakers make no future commitment other than to follow their best judgement
  • Subject to time inconsistency
    • Implies that a policy will have better inflation performance in the long run if it does not try to surprise people with unexpected expansionary policies, but sticks to a certain rule
67
Q

What are policy rules?

A
  • Binding plans that specify how policy will respond to particular contingencies
  • Types of rules
    • Non-activist rules
      • Do not react to economic acticity
      • Milton Friedmans constant money growth rate rule
        • The money supply is kept growing at a constant rate regardless of the state of the economy
    • Activist rules
      • Monetary policy reacts to changes in economic activity like the level of output and inflation
68
Q

What are the pros/cons of policy rules?

A
  • Pros
    • Solves time inconsistency: desirable long run outcomes
    • Delineates the political business cycle
  • Cons
    • Can be too rigid: cannot see every contingency
    • Do not easily incorporate the use of judgment because some critical information is not quantifiable
    • Lack of empirical consensus on correct economic model
    • Structural changes lead to changes in model coefficients (Lucas critique)
69
Q

What is constrained discretion?

A
  • Nominal anchor: some target e.g. inflation
  • Conceptual structure and inherent discipline
  • But with flexibility
  • Bernanke
  • Popular
70
Q

What difference does CB credibility make when faced with a positive AD shock?

A
  • MP desire is to tighten MP: shift AD2 back left to AD1 over the LR
  • SRAS: π = πe + ɣ(Y - YP) + 𝜌
    • Credible
      • πe will not change
      • SRAS will stay at AS1
    • Not credible
      • πe will change
      • SRAS will shift up to AS3
      • Larger inflation increase
71
Q

What difference does CB credibility make when faced with a negative AD shock?

A
  • Monetary easing required
  • Credible
    • πe will not change
    • SRAS will stay at AS1
  • Not credible
    • πe will change
    • SRAS will shift up to AS3
    • Larger inflation increase
72
Q

What difference does CB credibility make when faced with a positive SRAS shock?

A
  • Credible
    • πe will not change
    • SRAS will shift up to AS2
  • Not credible
    • πe will change
    • SRAS will shift up to AS3
    • Larger inflation increase
73
Q

Why is credibility important?

A
  • If it has credibility, can overcome time inconsistency and lower fluctuations in inflation and output
  • Higher credibility: faster inflation response and lower output loss
74
Q

How can credibility be achieved?

A
  • Inflation target
    • Public announcement of medium term numerical target
    • Institutional commitment to price stability as primary objectives
    • Information inclusive approach to establishing variables
    • Increased transparency
    • Increased accountability
  • Appoint ‘conservative’ central bankers
    • Perception of less tendency towards expansionary policy
75
Q

Broadly what are the MP transmission mechanisms?

A
  • 1: Traditional interest rate channel
  • 2: Other Asset Price Channels
  • 3: Credit view
76
Q

What is the traditional interest rate channel

A
  • Interest rates: investment: AD
  • Emphasis on real interest rate
  • Real long term interest rate viewed as having most impact on spending
  • CB’s affect SR nominal int rates: can only affect r if prices are sticky (∆π < ∆i)
  • Expectation hypothesis: LR is average of SR rates
77
Q

What are the other asset price channels?

A
  • Forex rates

* Equities

78
Q

What is the forex rate channel?

A

Decreasing r: decrease D domestic assets/currency: D exports increase: XM increases: AD

79
Q

What are the equities channels?

A
  • Tobin’s q Theory

* Wealth effects

80
Q

What is the Tobin’s Q channel?

A
  • MP affects valuation of equities
  • Defines q as the market value of firms divided by the replacement cost of capital
  • If q is high, the market price of firms is high relative to the replacement cost of capital, and new plant and equipment capital is cheap relative to the market value of firms: firms can issue new stocks and get a higher price: increase I: Increase AD
  • When q is low, firms will not purchase new investment goods because the market value of firms is low relative to the cost of capital
  • Decrease i/r: increase P stocks: increase q: increase I: AD
81
Q

What is the wealth effects channel?

A
  • C smoothing: lifetime resources (not housing)
  • Lifetime resources includes financial wealth and common stock
  • When stock prices rise, the value of financial wealth increases, thereby increasing the lifetime resources of consumers, and consumption should rise
  • Decrease i/r: increase P stocks: increase wealth: increase C : AD
82
Q

What are the credit view channels?

A
  • Frictions in the credit market
  • Bank lending channel
  • Balance sheet channels
  • Unanticipated Price Level channel
83
Q

What is the bank lending channel?

A
  • Based on the analysis that demonstrates that banks play a special role in the financial system because they are especially well suited to solve asymmetric information problems
  • Expansionary MP: increase reserves: increased deposits: increase I: AD
84
Q

What are the balance sheet channels?

A
  • Arises from the presence of financial frictions in credit markets
  • Firm’s B/S
  • Cash flow channel
  • Household liquidity effects
85
Q

What is the firm’s b/s channel?

A

Decrease i/r: Increase P stocks: increase firm’s net worth/collateral: decrease adverse selection/moral hazard problems: increase lending: I: AD

86
Q

What is the cash flow channel?

A
  • Affects cash flow: difference between cash receipts and cash expenditures
  • Decrease nominal short term i: increase firm/household cash flow: increased liquidity: decrease adverse selection/moral hazard problems: increase lending: I: AD
87
Q

What is the Household liquidity effects channel?

A
  • Negative income shock: need to see consumer durables or housing: loss on full value of asset as in a distress sale
  • If consumers held financial assets they could easily sell them quickly for their full market value and raise cash
  • Decrease i/r: Increase P stocks: increase households net worth/collateral: decrease odds of distress: Increase C/I AD
88
Q

What is the Unanticipated Price Level channel?

A

r: inflation: P: liabilities: firm real net worth: AD/MH: lending: I

89
Q

What is the importance of the transmission mechanise?

A
  • Evidence suggests financial frictions affect employment and spending decisions
  • Evidence that small firms are hurt more by tight MP (credit constraints)
  • Shouldn’t always associate easing or tightening MP with particular interest rate changes
  • Other assets prices besides those on SR debt instruments transmit effects
90
Q

How to derive IS?

A

Find A and plug in
OR
Solve Y = C + I + G + NX

91
Q

What happens in the wake of a temporary negative supply shock?

A

The supply shock causes the short-run aggregate supply curve to shift up.
The increase in inflation causes output to fall. Since higher-than-expected inflation is observed, expected inflation rises. At the same time, the negative output gap means there is less upward pressure on wages and prices. Moreover, the shock is now over and not expected to repeat. Thus, the second-round increase in inflation is smaller than expected, so expected inflation now adjusts downward, as observed inflation declines, until the output gap is eliminated.

92
Q

Suppose the economy is in a long-run equilibrium when a temporary, favorable aggregate supply shock occurs. What is the best policy?

A

AS shifting first right and then back to the left, so inflation returns to its original rate. If policy makers respond when the inflation rate falls below target, the output gap is enlarged, so AS will shift up and cause a positive inflation gap. If the policy response is to correct the output gap, the decrease in AD will enlarge the negative inflation gap. With no policy response, both the output and inflation gaps return to zero.

93
Q

Apart from SR supply shocks, how is AS affected?

A

Output gap: Labour Market: wage: cost of production: Prices: inflation expectation: SRAS

94
Q

How might fears of a zero lower bound justify expansion, even if the economy is not in a recession?

A
  • Policymakers were worried that a shock could push the economy into a deflationary spiral, in which the short-term nominal policy rate would be bound at the zero lower bound. 

  • At that point, conventional monetary policy would be ineffective. 

  • Policymakers viewed the risk of economic damage in the event of a deflationary spiral to be significant enough to overcome any potential inflation risk in
95
Q

How would a Friedman constant money growth rule affect MP in response to a severe downturn?

A
  • A severe downturn would result in the aggregate demand curve shifting sharply to the left.
    • With a strict constant money growth rule, this would result in a limited expansionary effect on aggregate demand, shifting aggregate demand partially back - a recessionary condition would still persist
    • The central bank could abandon the constant money growth rule and expand aggregate demand enough to move the economy back to potential output (at AD1), however this would be moving away from a rules-based policy, which helps keep credibility high and inflation expectations low.
96
Q

If A is credible and B is not, what will be the different outcomes to an AD policy?

A
  • In country A, the public will adjust inflation expectations in anticipation of changes in future policy. 

    • As a result, aggregate supply will adjust quickly to policy announcements
    • If the central banks both announce an autonomous tightening policy, the aggregate supply curve will shift down much quicker in country A than country B. 

    • With no credibility, country B would likely have to contract aggregate demand first and let expectations adjust after the policy is implemented to achieve the same lower long- term inflation rate as country A. 

    • The implication is that output will be more stable in country A than in country B, and the adjustment process is faster in country A than country B.
97
Q

What transmission mechanisms involve C?

A
  • Traditional
    - LR-r: negative spending
  • Wealth effects
    • Decrease i/r: increase P stocks: increase wealth: increase C: AD
  • Household liquidity effects
    • Decrease i/r: Increase P stocks: decrease risk of distress: Increase C
98
Q

What happens when the transmission mechanism aren’t functioning normally?

A

Less reliable AD shifts

99
Q

What transmission mechanisms involve I?

A
  • Traditional
    • Interest rates: investment:
  • Tobin’s q Theory
    • Decrease i/r: increase P stocks: increase q: increase I
  • Bank lending channel
    • Expansionary MP: increase reserves: increased deposits: increase I: AD
  • Firm’s B/S
    • Decrease i/r: Increase P stocks: increase firm’s net worth/collateral: decrease adverse selection/moral hazard problems: increase lending: I
  • Cash flow channel
    • Decrease nominal short term i: increase firm/household cash flow: increased liquidity: decrease adverse selection/moral hazard problems: increase lending: I: AD
  • Unexpected price level channel
    - Unexpected price increases lower value of firms’ liabilities (but not assets) and increases their net worth making banks more willing to lend
100
Q

What transmission mechanisms involve NX?

A
  • Exchange rate effect on NX

- Decreasing r: decrease D domestic assets/currency: D exports increase: XM increases: AD

101
Q

What does a yield curve mean?

A

An __ yield curve implies __ economic conditions as it indicates investors expect short term rates to ___ in anticipation of a ____, I.e rates will __ following a __ in the demand for borrowing

ECON2026 (8 decks)

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