T2 Topic 2: Dynamic AD and AS

Question 1

Overview of variables in DADAS model?

Answer 1

5 equations:

• 5 endogenous
• 4 exogenous
• 1 predetermined (in previous time period)
• 5 parameters

Question 2

Explain mechanism of monetary policy in DADAS?

Answer 2

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)

Question 3

What does π(t) represent?

Answer 3

The change in price level from t-1 to t

Question 4

What is the expectations operator?

Answer 4

The operator E(t) that defines the set of information available when the expectation is formed at time t

Question 5

How is demand for goods and services related to the real interest rate?

Answer 5

negatively

Question 6

What does α measure in the output equation?

Answer 6

How sensitive demand is to a change in r

Question 7

Explain the demand shock variable?

Answer 7

A random variables; fluctuates about 0

Question 8

What is ρ?

Answer 8

The natural rate of interest (if demand shock=0, r=ρ and tf Y=Y(bar))

Question 9

What does parameter Φ measure?

Answer 9

slope of inflation equation

Question 10

Change in inflation equation compared with modern form PC?

Answer 10

Uses output instead of U

Question 11

What is v(t)?

Answer 11

v(t) captures all exogenous influences on inflation
eg. supply shock
It’s another RV, avg=0

Question 12

What are adaptive expectations?

Answer 12

Forming expectations for future based on the past/current

Question 13

What do θpi and θY do?

Answer 13

They are parameters that govern the CB’s response to:
pi) inflation deviations from the target
Y) output deviations from its natural level

Question 14

How is the interest rate rule rewritten and what does it show?

Answer 14

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

Question 15

What happens if pi is at target rate and output at natural level?

Answer 15

r=ρ

tf real rate of interest = natural rate of interest

Question 16

What is the Taylor rule?

Answer 16

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)

Question 17

Main weakness of the Taylor rule?

Answer 17

It doesn’t work below a nominal interest rate of 0% due to Zero Lower Bound (ZLB)

Question 18

What si the LR equilibrium?

Answer 18

The LR position around which the economy fluctuates in the SR

Question 19

2 assumptions for LR equilibrium?

Answer 19

1) No shocks (demand or supply)

2) Inflation is stable, but not necessarily zero π(t)=π(t-1)

Question 20

Derive the LR equilibrium?

Answer 20

Now (see notes)

Question 21

Explain how you plot the SR DASAD curves?

Answer 21

π on y-axis
Y on x axis
(both variables endogenous)
Substitute any other endogenous variables to get equations (do proofs!)

Question 22

Explain the SR DAS curve and draw it?

Answer 22

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

Question 23

What shifts the SR DAS curve and why?

Answer 23

The curve is drawn for given values of π(t-1), Y(bar(t)), and v(t)
When these variables change, the curve shifts!

Question 24

Derive the dynamic AD curve?

Answer 24

See notes!

Question 25

3 interpretations of the dynamic AD curve?

Answer 25

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

Question 26

Does interest rate rule act through DAD or DAS? Why?

Answer 26

Interest rate rule (and tf MP) acts through DAD since interest rate rule parameters feature in the DAD equation

Question 27

Why is the DAD curve DWS?

Answer 27

High inflation -> CB raise nominal interest rates -> fall in GandS demand

Question 28

What shifts the DAD curve and why?

Answer 28

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!

Question 29

Draw full DADAS diagram?

Answer 29

Now (see notes)

Question 30

Summary

Answer 30

2 endgogenous variables depend on 4 exogenous variables, one predetermined variables and 4/5 of our parameters (not ρ)

Question 31

Explain the dynamic link between periods?

Answer 31

Inflation today becomes tomorrow’s predetermined inflation

Question 32

Putting the model to work?

Answer 32

Assume beginning at LR eq., then change one exogenous variables holding others constant

Question 33

3 causes of LR growth (growth in natural rate)?

Answer 33

population growth
capital accumulation
technological progress

Question 34

Mechanism for LR growth through Y(bar)? How much does it shift?

Answer 34

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)

Question 35

Draw diagram for LR growth (growth in natural rate)?

Answer 35

Now (see notes)

Question 36

Explain a supply shock through v(t)?

Answer 36

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)

Question 37

Explain the mechanism of a supply shock through v(t)?

Answer 37

Adverse supply shock -> increase in inflation and decrease in Y

Question 38

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?

Answer 38

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

Question 39

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?

Answer 39

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)

Question 40

Explain how a change in monetary policy through a change in target inflation rate mechanism works? (eg. decrease in π*) draw diagram

Answer 40

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)

Question 41

Why does it take so long for π* to be reached?

Answer 41

Because of adaptive expectations - if using rational expectations would be much quicker!

Question 42

What does θ(π) describe? and example? (Taylor principle)

Answer 42

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))%

Question 43

What is the implication of θ(π)>0? (Taylor principle)

Answer 43

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

Question 44

Explain the stabilising effect of θ(π)>0?

Answer 44

See notes

Question 45

What would happen is -1

Answer 45

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)

Question 46

What is the Taylor principle?

Answer 46

For inflation to be stable, the CB must respond to an increase in inflation with an even greater increase in the nominal interest rate

Question 47

See

Answer 47

Notes and slides on US data