A dynamic approach to short run economic fluctuations. The DAD/DAS model Part 3 The long run equilibrium & short run fluctuations.
The DAD-DAS model s long-run equilibrium Recall the long-run equilibrium values in the DAD-DAS theory: Y t rt t Y t * t * t t 1 t E i t * t In the short-run, the values of the various variables fluctuate around the long-run equilibrium values.
Long run growth Suppose that the economy is its long run equilibrium, when natural (long-run) level of GDP increases
Long-run growth π Y t Y t +1 DAS t DAS t +1 π t = π t + 1 A B Period t + 1: Long-run growth increases the natural rate of output. Y t DAD t Y t +1 DAD t +1 Y New equilibrium at B. Income grows but inflation remains stable.
Long-Run Growth Therefore, starting from long-run equilibrium, if there is an increase in the natural GDP, actual GDP will immediately increase to the new natural GDP, and none of the other endogenous variables will be affected
Supply Shock Suppose the economy is in long-run equilibrium The supply shock hits for one period (ν t > 0) and then goes away (ν t+1 = 0) Note that from the definition of a shock, we know that the long run equilibrium values are unchanged How will the economy be affected, both in the short run and in the long run?
What is a supply shock anyway? A temporary shock to costs of production. For an interesting discussion on what is and what isn t a supply shock, see: http://gregmankiw.blogspot.com/2009/04/whatare-supply-shocks.html
A shock to aggregate supply π Y DAS t Period t: Supply shock (ν t > 0) shifts DAS upward; inflation rises, central bank responds by raising real interest rate, output falls. DAS t +1 π t π t + 1 π t + 2 π t 1 B C D A ν t DAS t +2 DAS t -1 Period t + 1: Supply shock is over (ν t+1 = 0) but DAS does not return to its initial position due to higher inflation expectations. Y t Period t 1: initial equilibrium at A Y t + 2 Y t 1 DAD Y This process continues until output returns to its natural rate. The long run equilibrium is at A.
The dynamic response to a supply shock t A one-period supply shock affects output for many periods. Y t
The dynamic response to a supply shock t Because inflation expectations adjust slowly, actual inflation remains high for many periods. t
The dynamic response to a supply shock t The behavior of the nominal interest rate depends on that of inflation and real interest rates. i t
Aggregate Demand Shocks Suppose the economy is at the long-run equilibrium Then a positive aggregated demand shock hits the economy for three successive periods (ε t = ε t+1 = ε t+2 > 0), and then goes away (ε t+3 = 0) How will the economy be affected in the short run? That is, how will the economy adjust over time?
A shock to aggregate demand Period t 1: initial equilibrium at A π Y DAS t +3 Period t: Positive demand shock (ε > 0) shifts DAD to the right; output and inflation rise. π t + 3 π t G D C B DAS t +2 DAS t + 1 DAS t -1,t Period t + 1 t+2: Higher inflation in t raised inflation expectations for t + 1, shifting DAS up. Inflation rises more, output falls. π t 1 A DAD t,t+1,t+2 Y t + 5 DAD t -1, t+3 Y t 1 Y t Y Periods t + 3 : DAD returns to its old level - recession in G.
After the shock From point G the economy by adjustments of the dynamic aggregate supply returns to the old equilibrium
The dynamic response to a 5-period demand shock t The demand shock raises output. When the shock ends, output falls below its natural level, and recovers gradually. Y t
The dynamic response to a demand shock t t The demand shock causes inflation to rise. When the shock ends, inflation gradually falls toward its initial level.
Stricter Monetary Policy Suppose an economy is initially at its long-run equilibrium Then its central bank becomes less tolerant of inflation and reduces its target inflation rate (π*) from 2% to 1% What will be the short-run effect? How will the economy adjust to its new long-run equilibrium?
A shift in monetary policy Period t 1: target inflation rate π* = 2%, initial equilibrium at A π t 1 = 2% π t π final = 1% π B Y t C Y A Z DAD t, t + 1, Y t 1, Y final DAS t -1, t DAS t +1 DAS final DAD t 1 Y Period t: Central bank lowers target to π* = 1%, raises real interest rate, shifts DAD leftward. Output and inflation fall. Period t + 1: The fall in π t reduced inflation expectations for t + 1, shifting DAS downward. Output rises, inflation falls. Subsequent periods: This process continues until output returns to its natural rate and inflation reaches its new target.
Stricter Monetary Policy At the date the target inflation is reduced, output falls below its natural level, and inflation falls too towards its new target level The real interest rate rises above its natural level (ρ) The effect on the nominal interest rate (i = r + π) is ambiguous On the following dates, output recovers and gradually returns to its natural level. Inflation continues to fall and gradually approaches the new target level. The real interest rate falls, gradually returning to its natural level (ρ) The nominal interest rate falls to its new and lower long-run level (i = ρ + π * )
The dynamic response to a reduction in target inflation * t Y t Reducing the target inflation rate causes output to fall below its natural level for a while. Output recovers gradually.
The dynamic response to a reduction in target inflation * t t Because expectations adjust slowly, it takes many periods for inflation to reach the new target.
The dynamic response to a reduction in target inflation * t r t To reduce inflation, the central bank raises the real interest rate to reduce aggregate demand. The real interest rate gradually returns to its natural rate.
The dynamic response to a reduction in target inflation * t i t The initial increase in the real interest rate raises the nominal interest rate. As the inflation and real interest rates fall, the nominal rate falls.
Conclusions Transitory shocks may have longer lasting effects on the economy Eventually however, the economy returns to its long run equilibrium; with LR output determined by the factors of production (K, N, A) & target inflation set by the central bank The DAD/DAS model is in fact an introduction to DSGE models used by central banks & other institutions to predict & analyze policy changes