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Intermediate Macroeconomics: Lecture 11: The Dynamic AS-AD Model, Part One

This lecture introduces the dynamic AS-AD model, which distinguishes between nominal and real interest rates and incorporates expectations and dynamics. It motivates the model by noting limitations of static models. It then outlines the key components of the dynamic AS-AD model, including the output equation, Fisher equation, Phillips curve, adaptive expectations, and Taylor rule for monetary policy. The lecture defines the dynamic AS (DAS) and AD (DAD) curves and shows how they determine short-run equilibrium. It concludes by previewing the next lecture on impact and dynamic effects within this framework.

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AlexRussell
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77 views

Intermediate Macroeconomics: Lecture 11: The Dynamic AS-AD Model, Part One

This lecture introduces the dynamic AS-AD model, which distinguishes between nominal and real interest rates and incorporates expectations and dynamics. It motivates the model by noting limitations of static models. It then outlines the key components of the dynamic AS-AD model, including the output equation, Fisher equation, Phillips curve, adaptive expectations, and Taylor rule for monetary policy. The lecture defines the dynamic AS (DAS) and AD (DAD) curves and shows how they determine short-run equilibrium. It concludes by previewing the next lecture on impact and dynamic effects within this framework.

Uploaded by

AlexRussell
Copyright
© © All Rights Reserved
Available Formats
Download as PDF, TXT or read online on Scribd
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Intermediate Macroeconomics

Lecture 11: the dynamic AS-AD model, part one

Semester 2, 2016

This lecture

Dynamic AS-AD model, part one: motivation and framework


Mankiw A dynamic model of aggregate demand and aggregate
supply, (available from the LMS), sections 14.114.2

This lecture

1- Motivation
limitation of the static IS-LM and AS-AD models
importance of nominal vs. real interest rates

2- Building blocks of the dynamic AS-AD model


3- The Taylor rule
4- DAD curve and DAS curve

Limitations of static models


Inadequate treatment of
distinction between nominal and real interest rates
expectations and dynamics
Consequently, static models are difficult to relate to policy

discussions, which are couched in terms of

output gaps
inflation vs. expected inflation
transitory vs. persistent shocks
impact vs. dynamic effects
policy rules

Nominal vs. real interest rates

Nominal interest rate it , expressed in terms of claims to currency

(e.g., dollars)
Real interest rate rt , expressed in terms of claims to a basket of

real goods (e.g., the CPI basket)

Nominal vs. real interest rates


(1 + rt )

1 good (CPI)

(1 + it )

Pt
dollars
Pt+1

Pt dollars

(1 + it )Pt dollars

date t

date t + 1

It costs Pt dollars to buy one unit of goods (e.g., the CPI). Invest to get (1 + it )Pt
dollars at t + 1. Real purchasing power of these dollars at t + 1 is (1 + it )Pt /Pt+1 ,
this is the real return on the investment (i.e., 1 + rt ).
6

Nominal vs. real interest rates


Exact relation

1 + rt = (1 + it )

Pt
Pt+1

Inflation

1 + t+1

Pt+1
Pt

Approximate relation

rt = it t+1
This is a good approximation when nominal interest rate and
inflation are not too large
Next periods price level not known in advance, so really should

write in terms of expected inflation


rt = it Et (t+1 )
7

Nominal vs. real interest rates

While nominal interest rates it have declined considerably since 1980, real interest
rates rt were actually higher in 2011.
8

Nominal and real rates in the IS-LM model


Investment demand depends on real interest rate

Y = C(Y, T ) + I(Y, r) + G
Money demand depends on nominal interest rate

M
= L(Y, i)
P
Monetary policy operates through nominal interest rate
Nominal interest rate and real interest rate are linked by

r = i E()
IS-LM implicitly assumes expected inflation E() is constant

Nominal and real rates in the AS-AD model

In AS-AD model, it is important to distinguish


real vs. nominal interest rates
short run effects vs. long run effects
To do this properly, we need a model which takes expectations and

dynamics seriously
dynamic AS-AD model

10

Overview of the dynamic AS-AD model


Five key building blocks
(1) Output equation: output depends negatively on real interest rate
(2) Fisher equation: real interest rate is nominal interest rate less
expected inflation
(3) Expectations-augmented Phillips curve: inflation depends on
expected inflation and output gap
(4) Adaptive expectations: expected future inflation equal to current
actual inflation
(5) Monetary policy rule: nominal interest rate set in response to
inflation and output gap
11

(1) Output equation


Simplified IS equation
Real output Yt depends negatively on real interest rate rt

Yt = Y (rt ) + t ,

>0

where
Yt
Y
rt

:
:
:
:
:

level of real output at date t


natural level of output
real interest rate
natural real interest rate
random shifts in aggregate demand, mean zero E(t ) = 0

If rt = , then E(Yt ) = Y
The term Yt Y is the output gap
12

(2) Fisher equation


As above, real interest rate rt is nominal interest rate it less

expected inflation
rt = it Et (t+1 )
where
t+1 : inflation rate between period t and period t + 1
Et () : expectations conditional on information available at date t
Actual inflation rate between t and t + 1 is not known at t, hence

the expectations

13

(3) Phillips curve

Inflation rate is given by expectations-augmented Phillips curve

t = Et1 (t ) + (Yt Y ) + vt ,

>0

where
Et1 () : expectations conditional on information available at date t 1
vt : random shifts in aggregate supply, mean zero E(vt ) = 0
Sensitivity of inflation to output gap given by > 0

14

(4) Adaptive expectations

Expected future inflation equal to current actual inflation

Et1 (t ) = t1
Similarly

Et (t+1 ) = t

15

(5) Monetary policy rule


Nominal interest rate it set by central bank according to rule

it = t + + (t ) + Y (Yt Y ),

, Y > 0

where
: central banks inflation target
: policy sensitivity to inflation above target
Y : policy sensitivity to output gap
According to Fisher equation, rt = it Et (t+1 ) but with adaptive

expectations Et (t+1 ) = t so this is equivalently


rt = it t = + (t ) + Y (Yt Y )
If t = and Yt = Y , then real rate equals natural real rate rt =
16

Taylor rule
John Taylor, Professor of Economics, Stanford, and former US

Treasury official
Suggested simple guide to Federal Reserve decisions

1
1
it = 2% + t + (t 2%) + (Yt Y )
2
2
Taylor principle policy rule should be such that nominal interest
rate increases more than one for one with inflation, that is
dit
>1
dt
If so, increase in nominal rate will also increase real rate. In terms
of the monetary policy rule used here
dit
= 1 +
dt
so this just requires > 0 (in original Taylor rule, = 1/2)
17

Taylor rule 1993

18

What does the Taylor rule say now?

19

Long run equilibrium


Long run equilibrium: inflation stable, (t = t1 ), and shocks at

their mean values (t = vt = 0)


Because of adaptive expectations, this implies inflation

expectations also stable


Et (t+1 ) = t = t1 = Et1 (t )
Phillips curve then implies output at natural level

Yt = Y
Demand for goods then implies real rate at natural rate

rt =
Fisher equation then implies

it = + t
Monetary policy rule then implies

t =
20

Long run equilibrium


Complete solution for long run values is therefore

Yt = Y

real output at natural level

rt =

real interest rate at natural rate

t =

Et (t+1 ) =

it = +

inflation at target
expected inflation also at target

nominal interest rate

Monetary policy does not affect long run equilibrium values of real

variables (monetary neutrality)


What about the short run?

21

Dynamic AS curve (DAS)

Using adaptive expectations and Phillips curve

t = t1 + (Yt Y ) + vt
An upward sloping relation between real output Yt and inflation t

with slope
Takes as given: (i) lagged inflation t1 , (ii) natural output Y , and

(iii) supply shocks vt


Changes in these variables shift the DAS curve

22

DAS curve at date t

23

Deriving the dynamic AD curve


Start with output equation

Yt = Y (rt ) + t
Use Fisher equation and adaptive expectations

Yt = Y (it t ) + t
Use monetary policy rule

Yt = Y (t + + (t ) + Y (Yt Y ) t ) + t
= Y ( (t ) + Y (Yt Y )) + t
Solve for output Yt to get

Yt = Y

1
(t ) +
t
1 + Y
1 + Y
24

Dynamic AD curve (DAD)


Finally have

Yt = Y

1
(t ) +
t
1 + Y
1 + Y

A downward sloping relation between real output Yt and inflation

t with slope /(1 + Y )


Takes as given: (i) inflation target , (ii) natural output Y , and

(iii) demand shocks t


Changes in these variables shift the DAD curve

25

DAD curve

26

Short run equilibrium: basic idea

27

Next lecture

Dynamic AS-AD model, part two: impact and dynamic effects


Mankiw A dynamic model of aggregate demand and aggregate
supply, (available from the LMS), sections 14.214.3

28

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