IN CHAPTER 15 how o incorporae dynamics ino he AD-AS model we previously sudied how o use he dynamic AD-AS model o illusrae long-run economic growh how o use he dynamic AD-AS model o race ou he effecs over ime of various shocks and policy changes on oupu, inflaion, and oher endogenous variables 0
Oupu: The Demand for Goods and Services Y Y ( r ) oupu naural level of oupu real ineres rae 0, 0 Negaive relaion beween oupu and ineres rae, same inuiion as IS curve.
Oupu: The Demand for Goods and Services Y Y ( r ) measures he ineres-rae sensiiviy of demand Y Naural rae of ineres. In absence of demand shocks, Y when r demand shock, random and zero on average
The Real Ineres Rae: The Fisher Equaion ex ane (i.e. expeced) real ineres rae r i E 1 nominal ineres rae expeced inflaion rae 1 E 1 increase in price level from period o +1, no known in period expecaion, formed in period, of inflaion from o +1
Inflaion: The Phillips Curve E ( Y Y ) 1 curren inflaion previously expeced inflaion 0 indicaes how much inflaion responds when oupu flucuaes around is naural level supply shock, random and zero on average
Expeced Inflaion: Adapive Expecaions E 1 For simpliciy, we assume people expec prices o coninue rising a he curren inflaion rae.
The Nominal Ineres Rae: The Moneary-Policy Rule * Y i ( ) ( Y Y ) nominal ineres rae, se each period by he cenral bank naural rae of ineres cenral bank s inflaion arge 0, 0 Y
The Nominal Ineres Rae: The Moneary-Policy Rule * Y i ( ) ( Y Y ) measures how much he cenral bank adjuss he ineres rae when inflaion deviaes from is arge measures how much he cenral bank adjuss he ineres rae when oupu deviaes from is naural rae
CASE STUDY The Taylor rule Economis John Taylor proposed a moneary policy rule very similar o ours: where i ff = π+ 2 + 0.5 (π 2) 0.5 (GDP gap) i ff = nominal federal funds rae arge GDP gap = 100 x Y Y Y = percen by which real GDP is below is naural rae The Taylor rule maches Fed policy fairly well.
-3-2 -1 0 1 2 3 4 5 6 7 8 9 10 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 percen CASE STUDY The Taylor rule acual federal funds rae Taylor s rule
The model s variables and parameers Endogenous variables: Y E 1 r i Oupu Inflaion Real ineres rae Nominal ineres rae Expeced inflaion
The model s variables and parameers Exogenous variables: Y Naural level of oupu * Cenral bank s arge inflaion rae Demand shock Supply shock Predeermined variable: 1 Previous period s inflaion
The model s variables and parameers Parameers: Y Responsiveness of demand o he real ineres rae Naural rae of ineres Responsiveness of inflaion o oupu in he Phillips Curve Responsiveness of i o inflaion in he moneary-policy rule Responsiveness of i o oupu in he moneary-policy rule
The model s long-run equilibrium The normal sae around which he economy flucuaes. Two condiions required for long-run equilibrium: There are no shocks: 0 Inflaion is consan: 1
The model s long-run equilibrium Plugging he preceding condiions ino he model s five equaions and using algebra yields hese long-run values: Y r Y * * 1 E i *
The Dynamic Aggregae Supply Curve The DAS curve shows a relaion beween oupu and inflaion ha comes from he Phillips Curve and Adapive Expecaions: (DAS) ( Y Y) 1
The Dynamic Aggregae Supply Curve π 1 ( Y Y ) DAS DAS slopes upward: high levels of oupu are associaed wih high inflaion. Y DAS shifs in response o changes in he naural level of oupu, previous inflaion, and supply shocks.
The Dynamic Aggregae Demand Curve To derive he DAD curve, we will combine four equaions and hen eliminae all he endogenous variables oher han oupu and inflaion. Sar wih he demand for goods and services: Y Y ( r ) Y Y ( i E ) 1 using he Fisher eq n
The Dynamic Aggregae Demand Curve resul from previous slide Y Y ( i E ) 1 Y Y ( i ) using he expecaions eq n using moneary policy rule Y Y Y Y * [ ( ) Y ( ) ] Y Y Y Y * [ ( ) Y ( )]
The Dynamic Aggregae Demand Curve resul from previous slide Y Y Y Y * [ ( ) Y ( )] combine like erms, solve for Y Y Y * A( ) B, (DAD) where 1 A 0, B 0 1 1 Y Y
The Dynamic Aggregae Demand Curve π Y Y * A( ) B DAD slopes downward: When inflaion rises, he cenral bank raises he real ineres rae, reducing he demand for goods & services. DAD Y DAD shifs in response o changes in he naural level of oupu, he inflaion arge, and demand shocks.
The shor-run equilibrium π π A Y DAS In each period, he inersecion of DAD and DAS deermines he shor-run eq m values of inflaion and oupu. Y DAD Y In he eq m shown here a A, oupu is below is naural level.
A shock o aggregae supply π π + 2 π 1 π Y B C D A DAD Y Y + 2 Y 1 DAS DAS +1 DAS +2 DAS -1 Y Period : Supply shock (ν > 0) shifs DAS upward; inflaion rises, cenral bank responds by raising real ineres rae, oupu falls.
Parameer values for simulaions Y 100 * 2.0 1.0 2.0 0.25 The following graphs are called impulse response funcions. They naural show he rae response of ineres of is he endogenous 2 percen. variables o he impulse (he shock). 0.5 Y 0.5
A shock o aggregae demand π + 5 π π G Y F E D C B DAS +5 DAS +4 DAS +3 DAS +2 DAS + 1 DAS -1, Period : Posiive demand shock (ε > 0) shifs AD o he righ; oupu and inflaion rise. π 1 A DAD,+1,,+4 Y + 5 Y 1 DAD -1, +5 Y Y
The dynamic response o a demand shock Y The demand shock raises oupu for five periods. When he shock ends, oupu falls below is naural level and recovers gradually.
The dynamic response o a demand shock The demand shock causes inflaion o rise. When he shock ends, inflaion gradually falls oward is iniial level.
The dynamic response o a demand shock r The demand shock raises he real ineres rae. Afer he shock ends, he real ineres rae falls and approaches is iniial level.
The dynamic response o a demand shock i The behavior of he nominal ineres rae depends on ha of he inflaion and real ineres raes.
A shif in moneary policy π 1 = 2% π π final = 1% π B Y C Y A Z Y 1, DAD, + 1, DAS -1, DAS +1 DAS final DAD 1 Y Period : Cenral bank lowers arge o π* = 1%, raises real ineres rae, shifs DAD lefward. Oupu and inflaion fall. Y final
The dynamic response o a reducion in arge inflaion * Y Reducing he arge inflaion rae causes oupu o fall below is naural level for a while. Oupu recovers gradually.
The dynamic response o a reducion in arge inflaion * Because expecaions adjus slowly, i akes many periods for inflaion o reach he new arge.
* The dynamic response o a reducion in arge inflaion r To reduce inflaion, he cenral bank raises he real ineres rae o reduce aggregae demand. The real ineres rae gradually reurns o is naural rae.
* The dynamic response o a reducion in arge inflaion i The iniial increase in he real ineres rae raises he nominal ineres rae. As he inflaion and real ineres raes fall, he nominal rae falls.
IN CHAPTER 18: abou wo policy debaes: 1. Should policy be acive or passive? 2. Should policy be by rule or discreion? 34
Argumens for acive policy Recessions cause economic hardship for millions of people. The Employmen Ac of 1946: I is he coninuing policy and responsibiliy of he Federal Governmen o promoe full employmen and producion. The model of aggregae demand and supply (Chaps. 10 14) shows how fiscal and moneary policy can respond o shocks and sabilize he economy.
Argumens agains acive policy Policies ac wih long & variable lags, including: inside lag: he ime beween he shock and he policy response. akes ime o recognize shock akes ime o implemen policy, especially fiscal policy ouside lag: he ime i akes for policy o affec economy. If condiions change before policy s impac is fel, he policy may desabilize he economy.
Auomaic sabilizers definiion: policies ha simulae or depress he economy when necessary wihou any deliberae policy change. Designed o reduce he lags associaed wih sabilizaion policy. Examples: income ax unemploymen insurance welfare
The Lucas criique Due o Rober Lucas who won Nobel Prize in 1995 for his work on raional expecaions. Forecasing he effecs of policy changes has ofen been done using models esimaed wih hisorical daa. Lucas poined ou ha such predicions would no be valid if he policy change alers expecaions in a way ha changes he fundamenal relaionships beween variables.
An example of he Lucas criique Predicion (based on pas experience): An increase in he money growh rae will reduce unemploymen. The Lucas criique poins ou ha increasing he money growh rae may raise expeced inflaion, in which case unemploymen would no necessarily fall.
Rules and discreion: Basic conceps Policy conduced by rule: Policymakers announce in advance how policy will respond in various siuaions and commi hemselves o following hrough. Policy conduced by discreion: As evens occur and circumsances change, policymakers use heir judgmen and apply whaever policies seem appropriae a he ime.
Argumens for rules 1. Disrus of policymakers and he poliical process misinformed poliicians poliicians ineress someimes no he same as he ineress of sociey
Argumens for rules 2. The ime inconsisency of discreionary policy def: A scenario in which policymakers have an incenive o renege on a previously announced policy once ohers have aced on ha announcemen. Desroys policymakers credibiliy, hereby reducing effeciveness of heir policies.
Moneary policy rules a. Consan money supply growh rae Advocaed by moneariss. Sabilizes aggregae demand only if velociy is sable.
Moneary policy rules a. Consan money supply growh rae b. Targe growh rae of nominal GDP Auomaically increase money growh whenever nominal GDP grows slower han argeed; decrease money growh when nominal GDP growh exceeds arge.
Moneary policy rules a. Consan money supply growh rae b. Targe growh rae of nominal GDP c. Targe he inflaion rae Auomaically reduce money growh whenever inflaion rises above he arge rae. Many counries cenral banks now pracice inflaion argeing bu allow hemselves a lile discreion.
Cenral bank independence A policy rule announced by cenral bank will work only if he announcemen is credible. Credibiliy depends in par on degree of independence of cenral bank.
average inflaion Inflaion and cenral bank independence index of cenral bank independence