PART V Topics in

Macroeconomic Theory

A Dynamic Model of
Aggregate Demand and
Aggregate Supply
Chapter 15 of
Macroeconomics, 8th edition,
by N. Gregory Mankiw
ECO62 Udayan Roy
 Inflation and dynamics in the short
run
So far, to analyze the short run we have used
the Keynesian Cross theory, and
the IS-LM theory
Both theories are silent about
Inflation, and
Dynamics
This chapter presents a dynamic short-run
theory of output, inflation, and interest rates.
This is the model of dynamic aggregate demand
and dynamic aggregate supply (DAD-DAS)
 Introduction
The dynamic model of aggregate demand
and aggregate supply (DAD-DAS)
determines both
real GDP (Y), and
the inflation rate ()
This theory is dynamic in the sense that
the outcome in one period affects the
outcome in the next period
like the Solow-Swan model, but for the short
run
 Introduction
Instead of representing monetary
policy by an exogenous money
supply, the central bank will now be
seen as following a monetary
policy rule
The central banks monetary policy rule
adjusts interest rates automatically
when output or inflation are not where
they should be.
 Introduction
The
DAD-DAS model is built on the following
concepts:
the IS curve, which negatively relates the real
interest rate (r) and demand for goods and services
(Y),
the Phillips curve, which relates inflation () to the
gap between output and its natural level (),
expected inflation (E), and supply shocks (),
adaptive expectations, which is a simple model of
expected inflation,
the Fisher effect, and
the monetary policy rule of the central bank.
 Keeping track of time
The subscript t denotes a time period, e.g.
Yt = real GDP in period t
Yt 1 = real GDP in period t 1
Yt + 1 = real GDP in period t + 1
We can think of time periods as years.
E.g., if t = 2008, then
Yt = Y2008 = real GDP in 2008
Yt 1 = Y2007 = real GDP in 2007
Yt + 1 = Y2009 = real GDP in 2009
 The models elements
The model has five equations and
five endogenous variables:
output, inflation, the real interest rate,
the nominal interest rate, and expected
inflation.
The first equation is for output
 DAD-DAS: 5 Equations
Demand Equation
Fisher Equation
Phillips Curve
Adaptive Expectations
Monetary Policy Rule
The Demand Equation
Natural Real Natural
(or long- intere (or long-
run or st rate run) Real
potential) interest
Real GDP rate
Yt Yt (rt ) t
Rea Parameter Demand
l representing shock,
GD the response of represents
P demand to the changes in G,
real interest T, C0, and I0
rates
 The Demand Equation
Assumption: > 0; although the real interest
rate can be negative, in the long run people
will not lend their resources to others without
a positive return. This is the long-run real
interest rate we had calculated in Ch. 3
Yt Yt (rt ) t
> Positive when
0 C0, I0, or G is
Assumption: There is a higher than
negative relation between usual or T is
output (Yt) and interest rate lower than
(rt). The justification is the usual.
 IS Curve = Demand
Equation
This graph is from r
Ch. 11 A
rt
Assume the IS curve B

is a straight line
IS
Then, for any pair of Y
Yt
pointsA and B, or
r
C and Bthe slope
must be the same C
rt

B
IS
Yt Y
 IS Curve = Demand
Equation
Then, for any point r
(rt, Yt) on the line, rt
we get , a
constant. IS
Yt Y

rt

The long-run real equilibrium IS
interest rate of Figure 3-8 in Ch.
3 is now denoted by the lower- Yt Y
 IS Curve = Demand
Equation

Now, we also saw in Ch. 12 that the IS
curve can shift when there are changes
in C0, I0, G, and T
To represent all these shift factors, we
add the random demand shock, t.

Therefore, the IS curve of Ch. 12 gives

us this chapters demand equation
 IS Curve = Demand
Equation
Yt Yt (rt ) t
r r
t t

IS Demand
Yt Yt

The IS curve can simply be renamed

the Demand Equation curve
 Demand Equation Curve
Yt Yt (rt ) t
r
t Note that if increases
(decreases) by some amount,
the Demand equation curve

shifts right (left) by the same

Demand amount.
Note also that if increases
Yt (decreases) by some amount,
the Demand equation curve
shifts up (down) by the same
amount.
 DAD-DAS: 5 Equations
Demand Equation
Fisher Equation
Phillips Curve
Adaptive Expectations
Monetary Policy Rule
The Real Interest Rate: The Fisher Equation

rt it Et t 1
ex ante
(i.e. expected)
real interest nominal expected
rate interest inflation rate
rate

Assumption: The real interest rate is the inflation-

adjusted interest rate. To adjust the nominal interest
rate for inflation, one must simply subtract the
expected inflation rate during the duration of the
loan.
The Real Interest Rate: The Fisher Equation

rt it Et t 1
ex ante
(i.e. expected)
real interest nominal expected
rate interest inflation rate
rate

t 1 increase in price level from period t

to t +1,
Et t 1 not known in period t
expectation, formed in period t,
of inflation from t to t +1
We saw this before in Ch.
 DAD-DAS: 5 Equations
Demand Equation
Fisher Equation
Phillips Curve
Adaptive Expectations
Monetary Policy Rule
 Inflation: The Phillips Curve
t Et 1 t (Yt Yt ) t

current previously supply

inflation expected shock,
inflation random and
zero on
0 indicates how much average
inflation responds when
output fluctuates around
its natural level
 Phillips Curve
t Et 1 t Yt Yt t
Assumption: At any particular time,
inflation would be high if
people in the past were expecting it to be high
current demand is high (relative to natural
GDP)
there is a high inflation shock. That is, if prices
are rising rapidly for some exogenous reason
such as scarcity of imported oil or drought-
caused scarcity of food
 Phillips Curve
t Et 1 t Yt Yt t
Momentu Demand- Cost-push
m pull inflation
inflation inflation

This Phillips Curve can be seen as

summarizing three reasons for
inflation
 DAD-DAS: 5 Equations
Demand Equation
Fisher Equation
Phillips Curve
Adaptive Expectations
Monetary Policy Rule
 Expected Inflation: Adaptive Expectations

Et t 1 t

Assumption:
Assumption: people
people
expect
expect prices
prices to
to continue
continue
rising
rising at
at the
the current
current
inflation
inflation rate.
rate.
Examples: E20002001 = 2000; E20132014 =
2013; etc.
 DAD-DAS: 5 Equations
Demand Equation
Fisher Equation
Phillips Curve
Adaptive Expectations
Monetary Policy Rule
 Monetary Policy Rule
The fifth and final main assumption
of the DAD-DAS theory is that
The central bank sets the nominal
interest rate
and, in setting the nominal interest rate,
the central bank is guided by a very
specific formula called the monetary
policy rule
 Monetary Policy Rule
Current Parameter Parameter
inflation that that
rate measures measures
how strongly how
the central strongly the
bank central
responds to bank

it t t Yt Yt
the inflation responds to
gap * the GDP
t gap Y

Nominal Natural Inflation Gap: GDP Gap: The

interest real The excess of excess of
rate, set interest current current GDP
each rate inflation over over natural
period by the central GDP
the banks inflation
central target
 Example: The Taylor Rule
Economist John Taylor proposed a monetary policy
rule very similar to ours:
iff = + 2 + 0.5 ( 2) 0.5 (GDP gap)
where
iff = nominal federal funds rate target
GDP gap = 100 Yx Y
Y real GDP is below its
= percent by which
natural rate
The Taylor Rule matches Fed policy fairly
well.
 CASE STUDY
10
The Taylor Rule
9 actual
8 Federal
7
Funds rate

6
Percent
5

2 Taylors
1 rule
0
1987 1989 1991 1993 1995 1997 1999 2001 2003 2005 2007 2009
SUMMARY OF THE DAD-
DAS MODEL
The models variables and parameters
Endogenous variables:

Yt Output
t Inflation

rt Real interest rate

it Nominal interest rate
Et t 1 Expected inflation
The models variables and parameters
Exogenous variables:
Yt Natural level of output
Central banks target inflation rate
*
t

t Demand shock
t Supply shock
Predetermined variable:

t 1 Previous periods inflation

The models variables and parameters
Parameters:
Responsiveness of demand to
the real interest rate
Natural rate of interest
Responsiveness of inflation to
output in the Phillips Curve
Responsiveness of i to inflation
in the monetary-policy rule
Y Responsiveness of i to output
in the monetary-policy rule
 The DAD-DAS Equations

Yt Yt (rt ) t Demand Equation

rt it Et t 1 Fisher Equation

t Et 1 t Yt Yt t Phillips Curve

Et t 1 t Adaptive

it t t Y Yt Yt
Expectations
*
t
Monetary Policy
Rule
DYNAMIC AGGREGATE
SUPPLY
 Recap: Dynamic Aggregate
Supply
t Et 1 t Yt Yt t Phillips Curve
Et t 1 t Adaptive
Expectations
Et 1 t t 1

t t 1 Yt Yt t DAS Curve
 The Dynamic Aggregate Supply Curve
t t 1 Yt Yt t
t DAS
DAS slopes
slopes upward:
upward:
high
high levels
levels of
of output
output
DASt are
are associated
associated withwith
high
high inflation.
inflation. This
This is
is
t 1 t
because
because of of demand-
demand-
pull
pull inflation
inflation

Yt
Yt
 The Dynamic Aggregate Supply Curve
t t 1 (Yt Yt ) t

If you know
DAS2011 (a) the natural GDP
at a particular
2010 2011 date,
(b) the inflation
shock at that
date, and
(c) the previous
periods
inflation,
you can figure out
Ythe location of the
Y2011 DAS curve at that
date.
 The Dynamic Aggregate Supply Curve
t t 1 (Yt Yt ) t
Dont forget this:
when , the height of
the DAS curve is
DAS2015 always .
2014 2015 That is, when the
economy is at full
employment, the
height of the DAS
curve is inherited
inflation plus the
current supply
shock.
Y
Y2015
 Shifts of the DAS Curve
t t 1 (Yt Yt ) t
Any
Any increase
increase
(decrease)
(decrease) inin the
the
previous
previous periods
periods
DASt inflation
inflation or
or in
in the
the
current
current periods
periods
t 1 t inflation
inflation shock
shock shifts
shifts
the
the DAS
DAS curve
curve up up
(down)
(down) byby the
the same
same
amount
amount

Y
Yt
 Shifts of the DAS Curve
t t 1 (Yt Yt ) t
Any
Any increase
increase
(decrease)
(decrease) in in the
the
previous
previous periods
periods
DASt inflation
inflation or
or in
in the
the
current
current periods
periods
t 1 t inflation
inflation shock
shock shifts
shifts
the
the DAS
DAS curve
curve up up
(down)
(down) by by the
the same
same
Any
Any increase
amount
amountincrease
(decrease)
(decrease) in in natural
natural
GDP
GDP shifts
shifts the
the DAS
DAS
curve
curve right
right (left)
(left) by
by
the
the exact
exact amount
amount
Y of
of the
the change.
change.
Yt
 The DAS Curve: Summary
The DAS curve is upward sloping
When the economy is at full employment, the
height of the DAS curve equals inherited inflation
plus the current supply shock
When either the previous periods inflation or the
current periods inflation shock increases
(decreases), the DAS curve shifts up (down) by
the same amount
When natural GDP increases (decreases), the
DAS curve shifts right (left) by the same amount
Buckle up for some tedious algebra!

DYNAMIC AGGREGATE
DEMAND
 The Dynamic Aggregate Demand
Curve
The Demand
Y Yt (rt ) t
Equation
t rt it Et t 1
Fisher
Fisher
equation
equation
Yt Yt ( it Et t 1 ) t
Et t 1 t
adaptive
adaptive
expectation
Yt Yt ( it t ) t expectation
ss
 The Dynamic Aggregate Demand
Curve

it t t Y Yt Yt
*
t
monetary
monetary policy
policy
rule
rule
Yt Yt ( it t ) t

Yt Yt [ t ( t t* ) Y (Yt Yt ) t ] t

Yt Yt [ ( t t* ) Y (Yt Yt )] t
Were almost
 Dynamic Aggregate
Demand
Yt Yt [ ( t t* ) Y (Yt Yt )] t
Yt Yt ( t ) Y Yt Y Yt t
*
t

Yt Y Yt Yt ( t ) Y Yt t
*
t

(1 Y ) Yt (1 Y ) Yt ( t t* ) t
1
Yt Yt ( t t )
*
t This is the
1 Y 1 Y equation of
the DAD
Yt Yt A ( t t* ) B t curve!
 The Dynamic Aggregate Demand
Curve

DAD
DAD slopes
slopes downward:
downward:
When
When inflation
inflation rises,
rises, the
the central
central bank
bank
raises
raises the
the real
real interest
interest rate,
rate, reducing
reducing
the
the demand
demand for for goods
goods and
and services.
services.

Note that the DAD

equation has no dynamics
in it: it only shows how
DADt simultaneously measured
variables are related to
Y each other
 The Dynamic Aggregate Demand
Curve

t*

DADtB

Yt B t
Y
 The Dynamic Aggregate Demand
Curve

When the central banks target inflation
rate increases (decreases) the DAD
curve moves up (down) by the exact
same amount.

t* Note how monetary policy is

described in terms of the
target inflation rate in the
DADt2 DAD-DAS model

DADt1

Yt B t
Y
 Monetary Policy
In the IS-LM model, monetary policy was
described by the money supply or the
interest rate
Expansionary monetary policy meant M or i
Contractionary monetary policy meant M or
i
In the DAD-DAS model,
Expansionary monetary policy is *
Contractionary monetary policy is *
 The Dynamic Aggregate Demand
Curve

When the natural rate of output

t* increases (decreases) the DAD curve
moves right (left) by the exact same
amount.
When there is a positive (negative)
DADt2 demand shock the DAD curve moves
right (left) .
DADt1
A positive demand
shock could be an
Yt B t
Y increase in C0, I0, or G,
or a decrease in T.
 The Dynamic Aggregate Demand
Curve

The
The DADDAD curve
curve shifts
shifts right
right
or
or up
up if:
if:
1.
1. the
the central
central banks
banks target
target
inflation
inflation rate
rate goes
goes up,
up,
2.
2. there
there is
is aa positive
positive
DADt2 demand
demand shock,
shock, or
or
3.
3. the
the natural
natural rate
rate of
of
DADt1
output
output increases.
increases.
Y
 The DAD Curve: Summary
The DAD curve is downward sloping
When the central banks target inflation rate
increases (decreases), the DAD curve shifts
up (down) by the same amount
When natural GDP increases (decreases),
the DAD curve shifts right (left) by the same
amount
When the demand shock increases
(decreases), the DAD curve shifts right (left)
SUMMARY: DAS AND DAD
EQUATIONS
 Summary: DAS and DAD
Equations
DA t t 1 Yt Yt t
S

1
DA Yt Yt ( t t )
*
t
D 1 Y 1 Y
Note that there are two endogenous variablesYt
and tin these two equations
Therefore, we can solve for the equilibrium values
of Yt and t
 The Solution!

Using the equations in the previous slideand a lot of very tedious algebra
one can express output and inflation entirely in terms of exogenous variables,
parameters, shocks and pre-determined inflation. This is the algebraic solution
of the DAD-DAS model.
 The Solution!
And once we solve for the equilibrium
values of Yt and t,
we can use adaptive expectations to solve
for expected inflation: .
We can use the monetary policy rule to
determine the nominal interest rate

and the Fisher Effect to solve for the real

interest rate
 The Solution!

By substituting the previous slides solutions for output and inflation into the
monetary policy rule, we can then get the above solution for the nominal interest
rate. The Fisher equation can be used to solve for the real interest rate.

Please do not worry about the solution and its derivation. However, if you are
interested, please see
http://myweb.liu.edu/~uroy/eco62/ppt/zlb-educ130328.pdf , especially sections
4.1 , 8.1 (appendix) and 8.2 (appendix).
Summary: DAD-DAS Slopes and
Shifts
DAS
Upward sloping
If natural output
increases, DAS shifts
right by same amount
If previous-period inflation
increases, DAS shifts up
by same amount
If inflation shock
increases, DAS shifts up
by same amount
DAD
Downward sloping
If natural output
increases, DAD shifts
right by same amount
If target inflation
increases, DAD shifts up
by same amount
If demand shock
increases, DAD shifts
right
EQUILIBRIUM: SHORT-RUN
AND LONG-RUN
 Short-Run Equilibria
The economy is

in short-run
equilibrium at DAS2004
time t if output
and inflation D

200

are at the 4

intersection of
the DAD and
DAD2004
DAS curves for Y
time t. Y2004
 Short-Run Equilibria
Any increase in the
natural output ()
shifts both curves
right by the same DAS2004
amount. This raises
output by the same DAS2004*
D
amount and leaves 200 D*
inflation unchanged. 4

DAD2004*
DAD2004
Y
Y2004
 Short-Run Equilibria
Any increase in the
previous periods DAS2004*
inflation (t-1) or the
current inflation D* DAS2004
shock (t) will reduce
output and raise D
200
inflation right away
4
(stagflation).

DAD2004
Y
Y2004
 Short-Run Equilibria
Any increase in the
central banks
inflation target (*)
or the demand shock DAS2004
(t) will raise both D*
output and inflation D
200
right away.
4

DAD2004*
DAD2004
Y
Y2004
 Short-Run Equilibria
DAD-DAS Predictions, Current inflation in one year becomes past
Short-Run inflation in the next year.
Yt t
Therefore, any exogenous factors that affect
+ 0
inflation in 2016 will affect both output and
* + + inflation in 2017. This in turn, will affect both
t + + output and inflation in 2018. And so on and
on.
t +
t-1 + In this way, output and inflation can change
from one period to the next in the DAD-DAS
model even if there are no changes in the
economys shocks and parameters.

The question then is: Does this dynamic

process of change eventually come to an
end?
 Long-Run Equilibria
The short-run equilibrium at period t is
also a long-run equilibrium if, in the
absence of shocks, parameter changes,
and policy changes, it continues to be the
short-run equilibrium in subsequent
periods t + 1, t + 2, etc.
 Short-Run Equilibria that are
not Long-Run Equilibria
Y
DAS2002
DAS2003
B DAS2004
2002
C Lesson: An economy
2003 that is in short-run
D
200 equilibrium but not in
long-run equilibrium
Recall: The height 4
will changeeven
of the DAS at the though there are no
full-employment shocks. The
output equals the economy will move
previous periods along DAD towards
inflation plus the
DADall years
Y04 full employment.
current periods Y
Y02 Y03
inflation shock.
In this example, there is no
inflation shock in 2003 and 2004.
 A Short-Run Equilibrium that
is also a Long-Run Equilibrium
Y

DAS2014

2013 = 2014
A

DADall
Y
Y2014 years
If there are no shocks and all parameters are
constant, the outcome at A will continue
indefinitely
 Short-Run Equilibria Converge to
Long-Run Equilibrium
Y
DAS2002
DAS2003
B DAS2004
2002
2003 C
D
200 DAS2014
4

2013 = 2014
A

DADall
Y
Y2014 years
If the economy is at B, it will not stay there. It will move along the DAD
curve towards A, the long-run equilibrium. Once the economy reaches A,
it will stay there.
 Short-Run Equilibria Converge to
Long-Run Equilibrium
Y DAS2014

2013 = 2014
Z
DAS2004

C DAS2003
2004
2003 B DAS2002
200 A
2

DADall
years Y
Y2014
If there are no shocks and all parameters are constant, an economy initially at A
will move along the DAD curve towards Z, the long-run equilibrium. Once at Z, it
will stay there.
The Long-Run Equilibrium is
Stable
The last two slides show that:
The economy will not stay put if it is at a
short-run equilibrium that is not a long-run
equilibrium
One such equilibrium leads to another, even if
there are no shocks, no parameter changes,
and no policy changes
The economy invariably ends up in a long-run
equilibrium
A description of an economy in long-run equilibrium

DAD-DAS LONG-RUN
EQUILIBRIUM
 The DAD-DAS models long-run
equilibrium
This is the normal state around which the
economy fluctuates.
Definition: The economy is in long-run
equilibrium when inflation is stable (),
provided there are no shocks () or
parameter changes.
 Long-Run Equilibrium
DAS:
In long-run equilibrium all shocks are zero.
Therefore,
In long-run equilibrium inflation is stable ().
Therefore, in long-run equilibrium, GDP is
.
 Long-Run Equilibrium
1
Yt Yt ( t t )
*
t DA
1 Y 1 Y
D

Yt Yt ( t t* ) In long-run equilibrium
1 Y all shocks are zero

We just saw that, in long-run equilibrium,

GDP is .
Therefore, in long-run equilibrium, inflation is .
Moreover, by adaptive expectations, expected
inflation is: .
Long-Run Equilibrium
Y

DAS

*
A

DAD
Y
 Long-Run Equilibrium
The monetary policy rule is:
As and , we see that
the long-run nominal interest rate is ,
and the long-run real interest rate is
Solved!
 The DAD-DAS models long-run
equilibrium
To summarize, the long-run equilibrium values in
the DAD-DAS theory are essentially the same as
the long run theory we saw earlier in this course:
Yt Yt
rt In the short-run,
the values of the
t t *
various variables
fluctuate around
Et t 1 *
t
the long-run
equilibrium values.
it t
*
DAD-DAS SHORT-RUN
EQUILIBRIUM
 Recall: The short-run equilibrium

In
In any
any period
period t,t, the
the
Yt intersection
intersection of of DAD
DADtt and
and
DAS
DAStt determines
determines the the
DASt
short-run
short-run equilibrium
equilibrium
A
values
values ofof inflation
inflation and
and
t output
outputInat t.t. equilibrium
Inatthe
the equilibrium
shown
shown here
here at
at A,A,
output
output is
is below
below itsits
DADt natural
natural level.
level. In
In
other
other words,
words, the
the
Y DAD-DAS
DAD-DAS theory
theory is is
Yt fully
fully capable
capable ofof
explaining
explaining
recessions
recessions and
and
booms.
How does the economy respondin the short run and in the long
runto (i) an increase in potential output, (ii) a temporary inflation
shock, (iii) a temporary demand shock, and (iv) stricter monetary
policy?

DAD-DAS PREDICTIONS
 1. Long-Run Growth
Suppose an economy is in long-run equilibrium
We saw in Chapters 8 and 9 that an economys
natural GDP () can increase over time
What will be the effect of this on our five
endogenous variables in the short-run?
In what way will the economy adjust from the
old long-run equilibrium to the new long-run
equilibrium?
Recap: DAD-DAS Slopes and
Shifts
DAS
Upward sloping
If natural output
increases, shifts right
by same amount
If previous-period inflation
increases, shifts up by
same amount
If there is a positive
inflation shock (t > 0),
shifts up by same amount
DAD
Downward sloping
If natural output
increases, shifts right
by same amount
If target inflation
increases, shifts up by
same amount
If there is a positive
demand shock (t > 0),
shifts right
 Period
Period t:t: initial
initial
1. Long-run growth equilibrium
equilibrium at at AA
Period tt +
Period + 11:: Long-
Long-
Yt Yt +1 run
run growth
growth
increases
increases the the
DASt natural
natural rate
rate of
of
DASt +1 DAS
output.
output.
DAS shifts
shifts right
right by
by
t the
the exact
exact amount
amount of of
A B the
the increase
increase in in
=
t + 1 natural
natural GDP.
GDP.
DAD
DAD shifts
shifts right
right too
too
by
by the
the exact
exact amount
amount
DADt DADt +1 of
of the
the increase
increase in in
Y natural
natural GDP.
GDP.
Yt Yt +1 New
New equilibrium
equilibrium at at B.
B.
Income
Income growsgrows butbut
inflation
inflation remains
remains
 1. Long-run growth

Yt Yt +1
Note that the
economy goes
DASt directly from one
DASt +1 long-run equilibrium,
A, to another long-
t run equilibrium, B, as
A B soon at the natural
= GDP increases. There
t + 1 is no transition
period.

DADt DADt +1
Y
Yt Yt +1
 1. 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
 2. Inflation Shock
Suppose the economy is in long-run
equilibrium
Then the inflation shock hits for one period
(t > 0) and then goes away (t+1 = 0)
How will the economy be affected, both in
the short run and in the long run?
Recap: DAD-DAS Slopes and
Shifts
DAS
Upward sloping
If natural output increases,
shifts right by same amount
If previous-period inflation
increases, shifts up by
same amount
If there is a positive
inflation shock (t > 0),
shifts up by same amount
DAD
Downward sloping
If natural output
increases, shifts right by
same amount
If target inflation
increases, shifts up by
same amount
If there is a positive
demand shock (t > 0),
shifts right
 Period
Period tt ++ 2:
2: As
As inflation
inflation falls,
falls,
A shock to aggregate
inflation
inflation expectations
expectations fall,
fall,
supply DAS
DAS moves
moves downward,
downward,
output
output rises.
rises.
Y Period
Period tt ++ 1:
1: Supply
Supply
DASt
DASt +1 shock
shock is
is over
over (
(t+1 = 0)
t+1 = 0)
DASt +2
B
t but
but DAS
DAS does
does not not
C
return
return to
to its
its initial
initial
t + 2 t
DASt -1 position
D position due
due to to higher
higher
Period inflation
inflation expectations.
expectations.
Period t:t: Supply
Supply shock
shock (
(tt >> 0)
0)
t 1 A shifts
shifts DAS
DAS upward;
upward; inflation
inflation
rises,
rises, central
central bank
bank responds
responds by by
DAD raising
raising real
real interest
interest rate,
rate, output
output
falls. Y This process
falls.
Yt Yt + 2 Yt 1 continues until output
Period
Period tt 1:
1: returns to its natural
initial
initial equilibrium
equilibrium rate. The long run
A shock to aggregate supply:
one more time
Y
DAS2002
2001 + DAS2003
2002 B DAS2004
2002

2003 C
D 200
200 DAS2001
2
4

2000 = 2001
A

DAD
Y04
Y
Y02 Y03 Y01
 2. Inflation Shock
So, we see that if a one-period inflation
shock hits the economy,
inflation rises at the date the shock hits, but
eventually returns to the unchanged long-run
level, and
GDP falls at the date the shock hits, but
eventually returns to the unchanged long-run
level
What happens to the interest rates i and r?
 2. Inflation Shock

it t t Y Yt Yt
*
t

it t t Y Y
*
t Y t t

rt t *
t Y Y
Y t t

According to the monetary policy rule, the temporary spike in

inflation dictates an increase in the real interest rate,
whereas the temporary fall in GDP indicates a decrease in
the real interest rate
The overall effect is ambiguous, for both interest rates
We can do simulations for specific values of the parameters
and exogenous variables
 Recall: The Solution!

As we saw before, it is possible to express output and inflation entirely in terms

of exogenous variables, parameters, shocks and pre-determined inflation. The
monetary policy rule can then be used to solve for the nominal interest rate. The
Fisher equation can be used to solve for the real interest rate. These solutions
can be used to simulate the future outcomes for given values of the exogenous
 Parameter values for
simulations
Thus, we can interpret as the percentage
Thus, we can interpret as the percentage
Yt 100 deviation
deviation of
of output
output from
from its
its natural
natural level.
level.
2.0
*
t
The
The central
central banks
banks inflation
inflation target
target isis 22 percent.
percent.
AA 1-percentage-point
1-percentage-point increase
increase inin the
the real
1.0 interest
real
interest rate
rate reduces
reduces output
output demand
demand by by 11
percent
percent ofof its
its natural
natural level.
level.

2.0 The
The natural
natural rate
rate of
of interest
interest is
is 22 percent.
percent.
0.25 When
When output
output is
is 11 percent
percent above
above its
its natural
natural
level,
level, inflation
inflation rises
rises by
by 0.25
0.25 percentage
percentage point.
point.
0.5 These
These values
values are
are from
from the
the Taylor
Taylor Rule,
Rule, which
which
approximates
approximates the
the actual
actual behavior
behavior of
of the
the
Y 0.5 Federal
Federal Reserve.
Reserve.
Impulse Response Functions
The following graphs are called impulse
response functions.
They show the response of the
endogenous variables to the impulse, i.e.
the shock.
The graphs are calculated using our
assumed values for the exogenous
variables and parameters
 The dynamic response to a supply shock

AAone-period
one-period
supply
supply shock
shock
affects
affects output
output
for
for many
many
periods.
periods.
Yt
 The dynamic response to a supply shock

Because
Because
t inflation
inflation
expectations
expectations
adjust
adjust slowly,
slowly,
actual
actual inflation
inflation
remains
remains high
high
for
for many
many
periods.
periods.
t
 The dynamic response to a supply shock

The
The real
real
interest
interest rate
rate
takes
takes many
many
periods
periods toto
rt return
return to
to its
its
natural
natural rate.
rate.
 The dynamic response to a supply shock

The
The behavior
behavior
t
of
of the
the
nominal
nominal
interest
interest
rate
rate depends
depends

on
on that
that
of
of inflation
inflation
it and
and real
real
interest
interest
rates.
rates.
 3. A Series of Aggregate Demand
Shocks
Suppose the economy is at the long-run
equilibrium
Then a positive aggregated demand shock hits
the economy for five successive periods (t=
t+1= t+2= t+3= t+4 > 0), and then goes away
(t+5 = 0)
How will the economy be affected in the short
run?
That is, how will the economy adjust over time?
Recap: DAD-DAS Slopes and
Shifts
DAS DAD
Upward sloping
Downward sloping
If natural output
If natural output
increases, shifts right by
increases, shifts right by
same amount
same amount
If previous-period
If target inflation
inflation increases,
increases, shifts up by
shifts up by same
same amount
amount
If there is a positive
If there is a positive
demand shock (t > 0),
inflation shock (t > 0),
shifts right
shifts up by same amount
 Period
Period tt 1: 1:
A shock to aggregate demand initial
initial equilibrium
equilibrium
at
at AA
Period
Period t: Positive demand
t: Positive demand
DASt +5 shock
shock t(
Period (++>>1: 0) shifts
shifts AD
0)Higher AD toto
Y Period t 1: Higher
DASt +4 the
the right;
inflation
inflation
Periods right;in
tin+
output
output
t
t raised
2raised
to t
and
and
++inflation
inflation
4:
Periods
inflation t +
rise.2 to t 4:
inflation
expectations
expectations rise. for
forint + 1,
DASt +3 HigherHigher inflation
inflation int previous
+ 1,
previous
F shifting
shifting
period
period DAS
DAS up.
raises
raises up. Inflation
Inflation
inflation
inflation
G DASt +2 rises more,
more, output
t + 5 E rises
expectations,
expectations, shiftsfalls.
output
shifts falls.
DAS
DAS
DASt + 1 up. Period
Period
up. t
Inflation+
Inflation 5:
t + 5:rises,DAS
DAS output
rises, is
is
output
D higher
higher due
falls.
falls. due to to higher
higher
C DASt -1,t inflation
inflation in in preceding
preceding
t B period,
period, but but demand
demand shock shock
ends
ends and
and DAD
Periods
Periods DADtt ++ returns
and to
6returns
6 and to
its
its initial
initial
higher:
higher: position.
position.
t 1 A DADt ,t+1,,t+4Equilibrium
Equilibrium
DAS at
at G.G. shifts
DAS gradually
gradually shifts
down
down as as inflation
inflation and and
DADt -1, t+5
Y inflation
inflation expectations
expectations
Yt + 5 Yt 1 Yt fall.
fall. The
The economy
economy
gradually
gradually recovers recovers
and
and reaches
reaches the the long
long
run
run equilibrium
equilibrium at at A.
A.
 A 3-period shock to aggregate demand

Y DAS04
DAS03
0 D DAS02
3 0 C
DAS00,01
0
2
B
1
1999 = A DAD01,02,03
00 DAD00,04
Y
Y00 Y03 Y02Y01
When the demand shock first hits, output and inflation both increase. In the
two following periods, despite the continuing presence of the demand
shock, output starts to fall. Inflation continues to rise.
 3. A shock to aggregate demand

Y DAS04
DAS05
DAS06
0
E
3 0
0 F
4 DAS00,01
5

1999 = A
00 DAD00,04,05,06
Y
Y04 Y05 Y00
On the date the demand shock ends, output falls below the long-run level
and inflation finally begins to fall. After that, output rises and inflation falls
towards the initial long-run equilibrium.
 3. A 3-period shock to aggregate
demand
Y
Counter-
clockwise cycle

0 D
E
3 0
0
F C Clockwise
0 cycle
4
2
50 B unemployment

1
1999 = A
00
Y
Y04 Y05 Y00 Y03 Y02Y01
In short, after a positive demand shock we get a counter-clockwise cycle in
the output-inflation graph. But this is also a clockwise cycle in the
unemployment-inflation graph.
 Inflation-Unemployment
Cycles
Please see:
http://krugman.blogs.nytimes.com/2010/07/31/
clockwise-spirals
/

http://krugman.blogs.nytimes.com/2011/11/17/s
ubsiding-inflation
/

http://
krugman.blogs.nytimes.com/2012/04/08/unemp
 A Series of Aggregate Demand
Shocks: 4 Phases
1. On the date the multi-period demand shock first
hits, both output and inflation rise above their
long-run values
2. After that, while the demand shock is still present,
output falls and inflation continues to rise
3. On the date the demand shock ends, output falls
below its long-run value and inflation falls
4. After that, output recovers and inflation falls,
gradually returning to their original long-run
values
. What happens to the interest rates i and r?
 A Series of Aggregate Demand
Shocks: 4 Phases, interest rates
1. On the date the multi-period demand shock first hits, both
output and inflation rise above their long-run values. So,
interest rate rises
2. After that, while the demand shock is still present, output
falls and inflation continues to rise. Now, the effect on the
interest rate is ambiguous
3. On the date the demand shock ends, output falls below its
long-run value and inflation falls. So, the interest rate falls
4. After that, output recovers and inflation falls, gradually
returning to their original long-run values. Again, the effect
on the interest rate is ambiguous, but it does return to its
original long run value ()
 The dynamic response to a demand shock
The
The demand
demand
shock
shock raises
raises
t output
output for
for five
five
periods.
periods.
When
When thethe
shock
shock ends,
ends,
output
output falls
falls
below
below its
its
natural
natural level,
level,
and
and recovers
recovers
Yt gradually.
gradually.
 The dynamic response to a demand shock

The
The
demand
demand
t shock
shock causes
causes
inflation
inflation
to
to rise.
rise.
When
When the the
shock
shock ends,
ends,
inflation
inflation
gradually
gradually fallsfalls
t toward
toward its its
initial
initial level.
level.
 The dynamic response to a demand shock
The
The demand
demand
shock
shock raises
raises
t the
the real
real
interest
interest rate.
rate.
After
After the
the
shock
shock ends,
ends,
the
the real
real
interest
interest
rate
rate falls
falls and
and
approaches
approaches
rt its
its initial
initial level.
level.
 The dynamic response to a demand shock

The
The behavior
behavior
t
of
of the
the
nominal
nominal
interest
interest rate
rate
depends
depends on on
that
that
of
of the
the
inflation
inflation and
and
it real
real interest
interest
rates.
rates.
 4. 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 (*) from 2% to 1%
What will be the short-run effect?
How will the economy adjust to its new
long-run equilibrium?
Recap: DAD-DAS Slopes and
Shifts
DAS DAD
Upward sloping
Downward sloping
If natural output
If natural output
increases, shifts right by
increases, shifts right by
same amount
same amount
If previous-period
If target inflation
inflation increases,
increases, shifts up by
shifts up by same
same amount
amount
If there is a positive
If there is a positive
demand shock (t > 0),
inflation shock (t > 0),
shifts right
shifts up by same amount
 Period
Period tt 1:
1: target
target
A shift in monetary policy inflation
inflation rate
rate *
* == 2%,
2%,
initial
initial equilibrium
equilibrium atat A
A
Period
Period t:t: Central
Central bank
bank
Y lowers
lowers target
target toto *
* ==
DASt -1, t 1%,
1%, raises
raises real
real
A DASt +1 interest
interest rate,
rate, shifts
shifts
t 1 = 2% DAD
DAD leftward.
leftward. Output
Output
B
t and
and inflation
inflation fall.
fall.
C Period
Period tt ++ 1:1: The
The fall
fall
DASfina in
in
ttreduced
reduced inflation
inflation
expectations
expectations for for tt ++
l 1,
1, shifting
shifting DAS
DAS
final = 1% Z downward.
downward. OutputOutput
DADt 1 rises,
rises, inflation
inflation falls.
falls.
DADt, t + 1, Subsequent
Subsequent periods:
periods:
Y This
This process
process
Yt Yt 1 , continues
continues until
until
output
output returns
returns to to its
its
natural
natural rate
rate and
and
Yfinal inflation
inflation reaches
reaches its its
 4. 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 ()
The effect on the nominal interest rate (i = r + ) 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 ()
The nominal interest rate falls to its new and lower long-run
level (i = + *)
 The dynamic response to a reduction in
target inflation

Reducing
Reducing
the
the target
target
t*
inflation
inflation rate
rate
causes
causes
output
output toto fall
fall
below
below its
its
natural
natural level
level
for
for aa while.
while.
Output
Output
Yt recovers
recovers
gradually.
gradually.
 The dynamic response to a reduction in
target inflation

t*
Because
Because
expectations
expectations
adjust
adjust
slowly,
slowly,
itit takes
takes
many
many
periods
periods for for
t inflation
inflation to to
reach
reach the the
new
new target.
target.
 The dynamic response to a reduction in
target inflation

To
To reduce
reduce
inflation,
inflation,
t* the
the central
central
bank
bank raises
raises
the
the real
real
interest
interest rate
rate
to
to reduce
reduce
aggregate
aggregate
demand.
demand.
The
The real
real
rt interest
interest rate
rate
gradually
gradually
returns
returns to to its
its
natural
natural rate.
rate.
 The dynamic response to a reduction in
target inflation
The
The initial
initial
increase
increase in in
the
the real
real
t* interest
interest
rate
rate raises
raises
the
the nominal
nominal
interest
interest
rate.
rate.
As
As the
the
inflation
inflation
it and
and real
real
interest
interest
rates
rates fall,
fall,
the
the nominal
nominal
rate
rate falls.
falls.
 APPLICATION:
Output variability vs. inflation variability
A supply shock reduces output (bad)
and raises inflation (also bad).
The central bank faces a tradeoff between
these bads it can reduce the effect on
output,
but only by tolerating an increase in the
effect
on inflation.
 The DAD Equation
1
Yt Yt ( t t )
*
t
1 Y 1 Y
CASE 1: is large, Y is small
Therefore, a small increase in inflation is
accompanied by a large decrease in
output
That is, the DAD curve is flat
See the next slide
 APPLICATION:
Output variability vs. inflation variability
CASE 1: is large, Y is small
A
A supply
supply shock
shock
In
In this
this case,
case, aa small
small
shifts
shifts DAS
DAS up.
up.
change
change in in inflation
inflation
DASt has
has aa large
large effect
effect on
on
output,
output, soso DAD
DAD
DASt 1 is
is relatively
relatively flat.
flat.
t
t 1
The
The shock
shock has
has aa
DADt 1, t
large
large effect
effect on
on
Y output,
output, but
but aa small
small
Yt Yt 1
effect
effect on
on inflation.
inflation.
 The DAD Equation
1
Yt Yt ( t t )
*
t
1 Y 1 Y
CASE 2: is small, Y is large
Therefore, even a large increase in
inflation is accompanied by only a small
decrease in output
That is, the DAD curve is steep
See the next slide
 APPLICATION:
Output variability vs. inflation variability
CASE 2: is small, Y is large
In
In this
this case,
case, aa large
large
change
change in in inflation
inflation
DASt has
has only
only aa small
small
t effect
effect on
on output,
output, soso
DASt 1 DAD
DAD is is relatively
relatively
steep.
steep.
t 1
Now,
Now, the
the shock
shock has
has
DADt 1, t only
only aa small
small effect
effect on
on
Y output,
output, but
but aa big
big
Yt Yt 1 effect
effect on
on inflation.
inflation.
 APPLICATION:
Output variability vs. inflation
variability
The central bank must decide whether it
wants
Less variability in inflation, or
Less variability in output
It cant have less variability in both inflation
and output
 APPLICATION:
The Taylor Principle
The Taylor Principle (named after economist
John Taylor): The proposition that a central bank
should respond to an increase in inflation with an
even greater increase in the nominal interest rate
(so that the real interest rate rises). I.e., central
bank should set > 0.
Otherwise, DAD will slope upward, economy may
be unstable, and inflation may spiral out of control.
 APPLICATION:
The Taylor Principle
1
Yt Yt ( t t )
*
t (DAD)
1 Y 1 Y
it t ( t t* ) Y (Yt Yt ) (MP rule)

If > 0:
When inflation rises, the central bank increases the
nominal interest rate even more, which increases the
real interest rate and reduces the demand for goods
and services.
DAD has a negative slope.
 APPLICATION:
The Taylor Principle
1
Yt Yt ( t t )
*
t (DAD)
1 Y 1 Y
it t ( t t* ) Y (Yt Yt ) (MP rule)

If < 0:
When inflation rises, the central bank increases
the nominal interest rate by a smaller amount.
The real interest rate falls, which increases the
demand for goods and services.
DAD has a positive slope.
 APPLICATION:
The Taylor Principle
If DAD is upward-sloping and steeper than DAS,
then the economy is unstable: output will not return
to its natural level, and inflation will spiral upward
(for positive demand shocks) or downward (for
negative ones).
Estimates of from published research:
= 0.14 from 1960-78, before Paul Volcker
became Fed chairman. Inflation was high during
this time, especially during the 1970s.
= 0.72 during the Volcker and Greenspan years.
Inflation was much lower during these years.
See A Simple Treatment of the Liquidity Trap for Intermediate
Macroeconomics Courses, The Journal of Economic Education,
45(1), 36-55, 2014. PDF copy available at http://myweb.liu.edu/~
uroy/resume/myPDF/JEE-2014.pdf.

DAD-DAS + ZLB!
 DAD-DAS + ZLB!
When the nominal interest rate is a
positive number, we have seen that the
DAD equation is
When the central bank wants to set the
nominal interest rate at a negative
number, it wont get its wish. It will be
forced to set . In this case, the DAD
equation becomes
Why?
 The Dynamic Aggregate Demand
Curve (ZLB)
The Demand
Y Yt (rt ) t
Equation
t rt it Et t 1
Fisher
Fisher
equation
equation
Yt Yt ( it Et t 1 ) t
Et t 1 t
adaptive
adaptive
expectation
Yt Yt ( it t ) t expectation
ss

Zero Lower Bound

Surprise, the DAD curve is now positively sloped!
t

* O The regular DAD is negatively-sloped:

Yt
The DAD at ZLB is positively-sloped:

There are two long-run equilibria: O and D! The

long-run equilibrium that the textbook
discusses is O, the orthodox long-run
equilibrium. The new one is D, the deflationary
long-run equilibrium, for the ZLB world.
t
DASO (t 1 = *; t =
0) If inflation is higher
* O than , the
negative of the
natural real interest
rate, at any date,
there is nothing to
r R DASR (t 1 = R < r; t = 0)worry: the economy
will converge
R R gradually to the
R
long-run equilibrium
at O.
Yt
DASD (t 1 = ; t =
0)
D

D
There are two long-run equilibria: O and D! The
long-run equilibrium that the textbook
discusses is O, the orthodox long-run
equilibrium. The new one is D, the deflationary
long-run equilibrium, for the ZLB world.
The new long-run
equilibrium at D
is unstable! For
example, if the
economy is at B,
it will move to F
and then to G,
etc. In other
words, the
economy will
move away from
the long-run
equilibrium at D
and enter a
deflationary
spiral. Output
and inflation will
both keep falling
and falling. Very
scary!
The natural real
interest rate ()
has been falling
since the 1980s
and has become
negative lately.
The natural real
interest rate ()
has been falling
since the 1980s
and has become
negative lately.
This brings the
deflationary long-
run equilibrium,
D, closer to the
stable long-run
equilibrium, O.
This increases
the chance that a
shock could
throw a perfectly
fine economy
into the dreaded
deflationary
spiral. Very
scary!
DAD-DAS + ZLB!