Stabilization Policy and the AS/AD

— Week 10 —

Vivaldo Mendes

Dep. of Economics — Instituto Universitário de Lisboa

19 November 2019

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Summary

1 Monetary Policy Rules and Aggregate Demand

2 The Aggregate Supply Curve
3 The AS/AD Framework
4 Macroeconomic Events in the AS/AD Framework
5 Empirical Evidence
6 Stabilization Policy and the AS/AD
7 Modern Monetary Policy
8 Required reading

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I –Monetary Policy Rules and Aggregate
Demand

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 Monetary Policy Rules and Aggregate Demand

The short-run model: three basic equations

1 The model implies that high short-run output leads to an increase in

in‡ation ... and vice versa
2 The central bank chooses how to make this trade-o¤ by choosing the
interest rate.
3 How does the CB set Rt ? A monetary policy rule.

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 Monetary Policy Rules and Aggregate Demand

A monetary policy rule

1 A set of instructions that determines the stance of monetary policy

for a given situation that might occur in the economy
2 The rule we consider is that the stance of monetary policy depends
on: current in‡ation and the In‡ation target
3 If in‡ation is above the target: the real interest rate should be high
4 If in‡ation is below the target: the real interest rate should be low

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 Monetary Policy Rules and Aggregate Demand

A monetary policy rule

Real Long run

interest rate interest Current Inflation
rate inflation target

Governs how aggressively monetary

policy responds to inflation

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 Monetary Policy Rules and Aggregate Demand

The AD Curve

1 Substitute the monetary policy rule into the IS curve

2 The resulting equation is the aggregate demand (AD) curve

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 Monetary Policy Rules and Aggregate Demand

The AD curve

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 Monetary Policy Rules and Aggregate Demand

The AD curve: main points

1 Describes how the central bank chooses short-run output based on

the rate of in‡ation.
2 If in‡ation is above target: the central bank raises the interest rate to
lower output below potential.
3 If in‡ation is below target: the central bank lowers the interest rate to
increase output above potential.

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 Monetary Policy Rules and Aggregate Demand

A change in in‡ation

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 Monetary Policy Rules and Aggregate Demand

A high value of m: aggressive monetary policy

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 Monetary Policy Rules and Aggregate Demand

Shifts of the AD Curve

1 AD curve shifts to the right if:

1 Parameter ā increases
2 The target rate of in‡ation π̄ increases
2 Moves to the left if ...

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 Monetary Policy Rules and Aggregate Demand

II –The Aggregate Supply Curve

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 The Aggregate Supply Curve

The aggregate supply (AS) curve is:

The price-setting equation used by …rmsThe Phillips curve with a new

name

Inflation in last
Current time period
inflation

Parameters
1

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 The Aggregate Supply Curve

The aggregate supply curve

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 The Aggregate Supply Curve

III –The AS/AD Framework

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 The AS/AD Framework

Combining the AS and AD curve

1 Two equations
2 Two unknowns

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 The AS/AD Framework

The Steady State

1 In the steady state:

1 the endogenous variables are constant over time
2 no shocks to the economy.
3 the in‡ation rate must be constant and short-run output is equal to
zero
2 Steady state implies:

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 The AS/AD Framework

The Steady State: graphically

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 The AS/AD Framework

IV –Macroeconomic Events in the

AS/AD Framework

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 Macroeconomic Events in the AS/AD Framework

Event #1: An In‡ation Shock

1 The economy begins in steady state and is hit with a lasting increase
in the price of oil.
2 Thus, the parameter ō is positive for one period
3 The AS curve will shift up as a result.
4 Stag‡ation: stagnation of economic activity accompanied by in‡ation.
5 How? Let’s see.

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 Macroeconomic Events in the AS/AD Framework

An In‡ation Shock: initial response

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 Macroeconomic Events in the AS/AD Framework

An In‡ation Shock: …nal result

It takes time to get back to the original equilibrium: in‡ation is sticky

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 Macroeconomic Events in the AS/AD Framework

Event #2: Disin‡ation

1 Suppose the economy begins in steady state

2 Policymakers decide to lower the target rate of in‡ation.
3 The AD curve shifts down

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 Macroeconomic Events in the AS/AD Framework

Disin‡ation: initial response

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 Macroeconomic Events in the AS/AD Framework

Disin‡ation: …nal result

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 Macroeconomic Events in the AS/AD Framework

Event #3: A Positive AD Shock

1 Suppose there is a temporary increase in the aggregate demand

parameter ā
2 The AD curve will shift out.
3 Prices increase.

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 Macroeconomic Events in the AS/AD Framework

A Positive AD Shock: initial response

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 Macroeconomic Events in the AS/AD Framework

A Positive AD Shock: …nal result

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 Macroeconomic Events in the AS/AD Framework

A Positive AD Shock: if the shock ends

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 Macroeconomic Events in the AS/AD Framework

A Positive AD Shock: summary

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 Macroeconomic Events in the AS/AD Framework

V –Empirical Evidence

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 Empirical Evidence

Predicting the Fed Funds Rate

1 The Fisher equation
2 Monetary policy rule in terms of the nominal interest rate

Nominal interest rate

Assume
m̄ = 1/2, r̄ = 2%, π̄ = 2%

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 Empirical Evidence

Actual and predicted level for the fed funds rate

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 Empirical Evidence

In‡ation-Output Loops

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 Empirical Evidence

VII –Modern Monetary Policy

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 Inside the Federal Reserve

Modern Monetary Policy: the essence

1 Central banks are now more explicit about policies and targets.
2 They react very aggressively against in‡ation
3 In‡ation rates in industrialized countries have been well behaved for
the last 25 years.

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 Inside the Federal Reserve

Low in‡ation

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 Inside the Federal Reserve

More Sophisticated Monetary Policy Rules

1 The simple policy rule we used considers only a reaction to in‡ation.

2 Richer monetary policy rules that use also short-run output create
results similar to the simpler model.
3 The Taylor Rule is such a rule
4 It considers also a reaction to the output gap

it = π t + Rt
= π t + r̄ + m̄(π t π̄ ) + n̄ Ỹt
| {z }
novelty

where n̄ is a parameter.

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 Inside the Federal Reserve

The Paradox of Policy and Rational Expectations

1 The goal of macroeconomic policy:

1 Full employment
2 Output at potential
3 Low, stable in‡ation
2 Remember adaptive expectations

π et = π t 1

3 Now ... Rational Expectations

π et = π t

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 Inside the Federal Reserve

The AS/AD Model with Rational Expectations

Remember that the AS curve is given by

If the Federal Reserve lowers the in‡ation target:

I The AD curve shifts down.
I If expectations adjust immediately and people use all information, the
AS curve shifts down immediately to the new target.
In‡ation can be kept low without recessions.

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 Inside the Federal Reserve

Rational Expectations and costless disin‡ation

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 Inside the Federal Reserve

VII –Required readings

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 Inside the Federal Reserve

Required reading

For this week you are required to read Read Chapter 13 of our adopted
textbook.
Charles I. Jones (2014). Macroeconomics, Third Edition, W. W.
Norton & Company.

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