T2 Topic 2: Dynamic AD and AS Flashcards
Overview of variables in DADAS model?
5 equations:
- 5 endogenous
- 4 exogenous
- 1 predetermined (in previous time period)
- 5 parameters
Explain mechanism of monetary policy in DADAS?
Model expresses MP in terms of nominal interest rate (i):
1) Money supply adjusts to deliver the interest rate the CB desires
- allows MP to respond to state of economy (eg. with inflation target in mind)
What does π(t) represent?
The change in price level from t-1 to t
What is the expectations operator?
The operator E(t) that defines the set of information available when the expectation is formed at time t
How is demand for goods and services related to the real interest rate?
negatively
What does α measure in the output equation?
How sensitive demand is to a change in r
Explain the demand shock variable?
A random variables; fluctuates about 0
What is ρ?
The natural rate of interest (if demand shock=0, r=ρ and tf Y=Y(bar))
What does parameter Φ measure?
slope of inflation equation
Change in inflation equation compared with modern form PC?
Uses output instead of U
What is v(t)?
v(t) captures all exogenous influences on inflation
eg. supply shock
It’s another RV, avg=0
What are adaptive expectations?
Forming expectations for future based on the past/current
What do θpi and θY do?
They are parameters that govern the CB’s response to:
pi) inflation deviations from the target
Y) output deviations from its natural level
How is the interest rate rule rewritten and what does it show?
Rewritten by replacing i-pi with the real interest rate r
Show that CB effectively controls r, then affects demand for goods and services through the output equation
What happens if pi is at target rate and output at natural level?
r=ρ
tf real rate of interest = natural rate of interest
What is the Taylor rule?
It is an interest rate rule, a proposed guideline for how CBs should alter interest rates in response to economic conditions (see panopto 41 mins and US data)
Main weakness of the Taylor rule?
It doesn’t work below a nominal interest rate of 0% due to Zero Lower Bound (ZLB)
What si the LR equilibrium?
The LR position around which the economy fluctuates in the SR
2 assumptions for LR equilibrium?
1) No shocks (demand or supply)
2) Inflation is stable, but not necessarily zero π(t)=π(t-1)
Derive the LR equilibrium?
Now (see notes)
Explain how you plot the SR DASAD curves?
π on y-axis
Y on x axis
(both variables endogenous)
Substitute any other endogenous variables to get equations (do proofs!)
Explain the SR DAS curve and draw it?
The DAS curve shows the positive association between output Y and inflation π. Its UWS slope reflects the Phillips curve relationship. High levels of economic activity are associated positively with high levels of inflation, ceteris paribus
What shifts the SR DAS curve and why?
The curve is drawn for given values of π(t-1), Y(bar(t)), and v(t)
When these variables change, the curve shifts!
Derive the dynamic AD curve?
See notes!
3 interpretations of the dynamic AD curve?
a) if inflation=target rate AND demand shock=0 then output equals its natural rate
b) if inflation0 then output is greater than its natural rate
c) if inflation>target rate OR demand shock<0 then output is less than its natural rate
Does interest rate rule act through DAD or DAS? Why?
Interest rate rule (and tf MP) acts through DAD since interest rate rule parameters feature in the DAD equation
Why is the DAD curve DWS?
High inflation -> CB raise nominal interest rates -> fall in GandS demand
What shifts the DAD curve and why?
DAD curve is drawn for fixed levels of natural output level, target inflation and demand shock
Tf change in any of these -> shift of DAD curve!
Draw full DADAS diagram?
Now (see notes)
Summary
2 endgogenous variables depend on 4 exogenous variables, one predetermined variables and 4/5 of our parameters (not ρ)
Explain the dynamic link between periods?
Inflation today becomes tomorrow’s predetermined inflation
Putting the model to work?
Assume beginning at LR eq., then change one exogenous variables holding others constant
3 causes of LR growth (growth in natural rate)?
population growth
capital accumulation
technological progress
Mechanism for LR growth through Y(bar)? How much does it shift?
increase in Y(bar) -> DAD and DAS move right -> growth in output and STABLE inflation
since Y(bar) features in both DAD and DAS equations the change in Y(bar) shifts both curves to the right by the full amount Y(bar)
Draw diagram for LR growth (growth in natural rate)?
Now (see notes)
Explain a supply shock through v(t)?
Supposing v increases by x% by one period, period t, then return back to zero -> inflation by full amount of shock (1%). Tf DAS shifts UP by x% aswell (draw diagram)
Explain the mechanism of a supply shock through v(t)?
Adverse supply shock -> increase in inflation and decrease in Y
For a supply shock through v, why does expected inflation remain elevated after shock has gone? What does this mean for output levels in subsequent periods?
Due to adaptive expectations; the monetary policy response to higher expected inflation is to raise interest rates -> lower economic activity in period Y(t+1), tf only in LR will economy return to point A (LR eq.) in diagram
With a demand shock through ε, we assume it is a persistent increase (eg. increase in Gov. spending for 5 periods), then returns to 0. Explain the mechanism for this, and draw the diagram to show it?
1) Positive demand shock -> increase in Y and inflation (DAD shifts right)
2) In subsequent periods, higher expected inflation -> DAS shifting upward
3) in ε(t+5) demand shock disappears and DAD returns to DAD(t-1), but Epi expectations are slow to adjust so DAS only shifts back gradually (see notes)
Explain how a change in monetary policy through a change in target inflation rate mechanism works? (eg. decrease in π*) draw diagram
1) decrease in π*->shift down of DAD (by same amount) -> decrease in output and π
2) Subsequent periods, lower Eπ tf DAS shifts down
3) Eventually economy approaches final equilibrium at D (Lower inflation but back at LR eq. growth)
Why does it take so long for π* to be reached?
Because of adaptive expectations - if using rational expectations would be much quicker!
What does θ(π) describe? and example? (Taylor principle)
How strongly the CB should respond to inflation
eg. If inflation exceeds target by 1%, the CB will increase the nominal interest rate by (1+ θ(π))%
What is the implication of θ(π)>0? (Taylor principle)
It means that in response to high inflation the CB will increase i by more than the amount inflation exceeds the target - this means that (under adaptive expectations) the CB will also increase the real interest rate
Explain the stabilising effect of θ(π)>0?
See notes
What would happen is -1
Weak response from CB leads to MP being a destabilising force
also DAD becomes UWS so inflation spirals out of control! (see notes both explanation)
What is the Taylor principle?
For inflation to be stable, the CB must respond to an increase in inflation with an even greater increase in the nominal interest rate
See
Notes and slides on US data
