AD-AS Model and Temporary Shocks

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Questions and Answers

What happens to output when there is a confidence slump?

Output decreases from Y* to Y1 (correct)

Output remains unchanged

Output increases from Y* to Y1

Output fluctuates unpredictably

What effect does a confidence slump have on inflation?

Inflation becomes volatile

Inflation remains constant

Inflation increases from π* to π1

Inflation decreases from π* to π1 (correct)

What is the long-term effect of an energy price spike on output?

Output permanently increases

Output stabilizes at a new level

Output continues to decrease

Output returns to Y* (correct)

How does a central bank react to an increase in inflation due to an energy price spike?

Increases real interest rates Signup and view all the answers

What does the shift of the AD curve during a confidence slump imply?

Decreased consumption demand Signup and view all the answers

Which statement best describes the short-term effect of an energy price spike on output?

Output decreases from Y* to Y1 Signup and view all the answers

What long-term condition remains invariant after a confidence slump?

Inflation returns to π* Signup and view all the answers

What does a decrease in consumption demand lead to during a confidence slump?

Decreased wages Signup and view all the answers

What happens to output following a temporary investment boom?

Output increases from Y* to Y1 due to higher investment demand. Signup and view all the answers

How does the AD curve respond to shocks to components of aggregate demand?

The AD curve shifts right with positive shocks and left with negative shocks. Signup and view all the answers

What does a higher reaction coefficient α indicate about a central bank's policy?

It suggests a stronger response to inflation, resulting in a flatter AD curve. Signup and view all the answers

In the long run, what is the relationship between inflation and output as per the model?

There is no relationship; long run output returns to Y* regardless of inflation. Signup and view all the answers

What is the effect of a confidence slump on the AD curve?

It shifts the AD curve to the left. Signup and view all the answers

What do households and firms assume about inflation expectations during a temporary investment boom?

They believe inflation expectations remain anchored despite short-term increases. Signup and view all the answers

What is the result of the short run Phillips Curve in the context of SRAS adjustments?

It suggests an inverse relationship between inflation and unemployment. Signup and view all the answers

What effect does an energy price hike typically have on the economy?

It reduces aggregate supply, shifting the SRAS curve left. Signup and view all the answers

What does the LRAS curve indicate about long-term output under ideal conditions?

Output converges to Y* irrespective of inflation levels. Signup and view all the answers

Which of the following best describes a permanent shock's effect on the economy?

It alters both short run and long run equilibrium outputs. Signup and view all the answers

What impacts the size of a recession according to the short-run aggregate supply (SRAS)?

The steepness of the SRAS curve Signup and view all the answers

Why is it important to have anchored inflation expectations?

It stabilizes long-run output and policy changes Signup and view all the answers

What distinguishes a demand shock from a supply shock?

Demand shocks originate from consumer behavior, while supply shocks come from production changes Signup and view all the answers

What will happen to expectations during an economic recovery?

They will fall in line with new targets Signup and view all the answers

Which slope parameter significantly impacts the short-run aggregate supply outcome?

The parameter alpha (α) Signup and view all the answers

What is a likely long-run impact of shocks on output growth?

A shift in long-term growth trends based on policy changes Signup and view all the answers

Which output scenario results from a flatter SRAS curve during a recession?

Lower output with more severe inflation Signup and view all the answers

What are the basic concepts that will be covered relating to savings in the next lecture?

Basic saving and investment concepts Signup and view all the answers

What happens to inflation and output in response to a positive demand shock?

Both inflation and output rise Signup and view all the answers

What is the effect of a negative supply shock on inflation and output?

Inflation rises and output falls Signup and view all the answers

If the AD curve is flat, what primarily occurs in response to a supply shock?

Most of the response is a change in output with little inflation change Signup and view all the answers

What determines the response size of inflation and output to a given shock?

The slopes of the demand and supply curves Signup and view all the answers

What occurs when potential output, Y*, permanently increases?

LRAS and LRAD curves shift outward without affecting inflation Signup and view all the answers

During disinflation, what happens to the AD curve?

It shifts down permanently along an unchanged SRAS curve Signup and view all the answers

What is the likely outcome during a recession caused by disinflation?

Output decreases while inflation expectations adjust Signup and view all the answers

What relationship exists between inflation and output when demand shocks are dominant?

Both inflation and output tend to move in the same direction Signup and view all the answers

How does a high value of α affect the AD curve's slope?

It flattens the AD curve, indicating aggressive central bank reactions Signup and view all the answers

What happens to inflation when there is a negative supply shock?

It rises alongside falling output Signup and view all the answers

The size of a recession is always deep if the short-run aggregate supply (SRAS) is steep.

False Signup and view all the answers

Anchored inflation expectations are crucial for economic stability.

True Signup and view all the answers

Disinflation is characterized by an increase in the rate of inflation.

False Signup and view all the answers

The long-run aggregate supply (LRAS) curve indicates the potential output of an economy under ideal conditions.

True Signup and view all the answers

An economy experiences recovery when expectations remain unchanged.

False Signup and view all the answers

Demand shocks impact aggregate demand the same way supply shocks impact aggregate supply.

True Signup and view all the answers

The impact of varying slope parameters within a model is irrelevant to economic interpretation.

False Signup and view all the answers

A confidence slump invariably leads to an increase in output.

False Signup and view all the answers

A decrease in consumer confidence leads to a leftward shift of the AD curve.

True Signup and view all the answers

An increase in energy prices typically results in a decrease in inflation.

False Signup and view all the answers

During a confidence slump, unemployment tends to rise as output decreases.

True Signup and view all the answers

Long-run equilibrium output is permanently affected by temporary shocks such as confidence slumps.

False Signup and view all the answers

The SRAS shifts upward when there is a spike in energy prices.

True Signup and view all the answers

Inflation expectations are usually not influenced during temporary economic events.

False Signup and view all the answers

A confidence slump typically leads to an increase in wages and business costs.

False Signup and view all the answers

Inflation and output return to their original levels after energy prices stabilize.

True Signup and view all the answers

An increase in investment demand leads to a decrease in unemployment.

True Signup and view all the answers

During an investment boom, inflation expectations are likely to become unanchored.

False Signup and view all the answers

In the long run, the AD curve will return to its original position after a temporary shock.

True Signup and view all the answers

When the AD curve shifts due to a confidence slump, output immediately increases.

False Signup and view all the answers

The long run aggregate supply (LRAS) curve indicates a direct relationship between inflation and output.

False Signup and view all the answers

The short-run aggregate supply (SRAS) curve is downward sloping.

False Signup and view all the answers

A permanent shock leads to both short run and long run effects on the economy.

True Signup and view all the answers

Higher real interest rates generally increase output in the economy.

False Signup and view all the answers

The AD curve becomes flatter when the central bank's reaction coefficient α is higher.

True Signup and view all the answers

Inflation expectations are consistent with the natural rate hypothesis over the long run.

True Signup and view all the answers

Positive supply shocks lead to rising inflation and falling output.

True Signup and view all the answers

A flat AD curve implies that changes in inflation have a large response in output.

False Signup and view all the answers

The LRAS curve shifts right when potential output increases permanently.

True Signup and view all the answers

During disinflation, output rises while inflation remains constant.

False Signup and view all the answers

A negative demand shock causes both inflation and output to rise.

False Signup and view all the answers

Inflation expectations can influence the shift of the SRAS curve during disinflation.

True Signup and view all the answers

A higher value of α indicates more aggressive central bank reactions to inflation.

True Signup and view all the answers

In the case of negative supply shocks, both inflation and output rise simultaneously.

False Signup and view all the answers

When the AD curve shifts down during disinflation, inflation and output both decline.

True Signup and view all the answers

Output can increase without affecting inflation during long-term growth in potential output.

True Signup and view all the answers

How do the slopes of the SRAS curve affect the severity of a recession?

A steep SRAS curve indicates a mild recession, while a flat SRAS curve leads to a deeper recession. Signup and view all the answers

What role do anchored inflation expectations play in economic stability?

Anchored inflation expectations contribute to predictability, allowing firms and households to make stable economic decisions. Signup and view all the answers

Distinguish between a demand shock and a supply shock in economic terms.

A demand shock affects the overall demand for goods and services, while a supply shock impacts the availability and production of goods. Signup and view all the answers

What is the significance of the central bank's policy reaction coefficient α?

A higher reaction coefficient α indicates that the central bank will respond more aggressively to deviations from its inflation target. Signup and view all the answers

In the context of disinflation, how does aggregate demand react?

During disinflation, the aggregate demand curve tends to shift left, reflecting reduced spending or confidence. Signup and view all the answers

What are the long-term implications of a positive demand shock on output growth?

A positive demand shock can lead to an increase in output growth if it raises productive capacity without causing inflation. Signup and view all the answers

Explain the relationship between potential output Y* and long-term economic growth.

Potential output Y* represents the maximum sustainable output level, shaping the economy's long-term growth trajectory. Signup and view all the answers

How do different slope parameters like γ and β influence short-run aggregate supply outcomes?

Different slope parameters such as γ and β affect how responsive the SRAS is to changes in demand and price level adjustments. Signup and view all the answers

What immediate effect does a decrease in consumer confidence have on the aggregate supply (AD) curve?

It causes the AD curve to shift leftward, leading to decreased output. Signup and view all the answers

How does a temporary energy price spike influence output and inflation in the short term?

Output decreases while inflation increases due to higher energy costs. Signup and view all the answers

What are the long-term economic outcomes following a confidence slump?

Output and inflation eventually return to their original levels as consumer confidence recovers. Signup and view all the answers

Explain the role of inflation expectations during a confidence slump.

Inflation expectations remain anchored, preventing a further decline in inflation despite lower output. Signup and view all the answers

What happens to real interest rates during an energy price spike, and how does it affect investment?

Real interest rates increase, leading to reduced investment and consumption. Signup and view all the answers

How does a decrease in consumption demand impact unemployment and wages during a confidence slump?

It increases unemployment and decreases wages due to lower output levels. Signup and view all the answers

What does the upward shift of the SRAS curve due to energy price spikes indicate about the economy?

It indicates reduced output and increased inflation, reflecting higher production costs. Signup and view all the answers

What is the relationship between output, inflation, and consumer confidence during an economic downturn?

Lower consumer confidence leads to decreased output and inflation in the short term. Signup and view all the answers

What is the effect of an investment boom on the AD curve?

An investment boom shifts the AD curve outward, leading to increased output and inflation in the short run. Signup and view all the answers

How does an increase in natural output affect the economy in the long run?

A permanent increase in natural output shifts the LRAS curve to the right, raising the potential output of the economy. Signup and view all the answers

What happens to inflation expectations during a temporary shock such as an energy price hike?

Inflation expectations typically remain anchored, meaning households and firms maintain their long-term inflation beliefs. Signup and view all the answers

How does the central bank typically respond to a significant inflation rise?

The central bank usually increases the real interest rate to combat rising inflation. Signup and view all the answers

What is the significance of the reaction coefficient α in the AD-AS model?

A higher α indicates a more aggressive response by the central bank to inflation, resulting in a flatter AD curve. Signup and view all the answers

Describe the long-run relationship between inflation and output according to the LRAS curve.

In the long run, the LRAS curve shows that output converges to its potential level Y*, independent of inflation. Signup and view all the answers

What happens to the SRAS curve during a positive demand shock?

The SRAS curve may shift upward due to increased costs from higher demand, leading to higher inflation. Signup and view all the answers

What occurs if inflation expectations change due to a sustained negative supply shock?

A change in inflation expectations can lead to a wage-price spiral, shifting the SRAS curve further left. Signup and view all the answers

Explain the implications of a confidence slump on the economy's output.

A confidence slump leads to a leftward shift in the AD curve, resulting in decreased output and increased unemployment. Signup and view all the answers

What role does the short-run Phillips Curve play in the AD-AS model's adjustments?

The short-run Phillips Curve illustrates the trade-off between inflation and unemployment, impacting output adjustments. Signup and view all the answers

What is the primary effect on inflation and output during a positive supply shock?

Inflation rises while output falls. Signup and view all the answers

How do anchored inflation expectations contribute to economic stability?

They prevent excessive fluctuations in actual inflation, aiding in maintaining steady output. Signup and view all the answers

What occurs if the AD curve is steep during a negative demand shock?

Both inflation and output decrease significantly. Signup and view all the answers

What happens to output and inflation if the central bank sets a lower inflation target?

Output decreases, and inflation decreases. Signup and view all the answers

What does a flatter AD curve imply regarding the central bank's reaction to inflation?

It suggests that the central bank reacts aggressively to rising inflation. Signup and view all the answers

When potential output, Y*, permanently increases, what is the impact on inflation?

Inflation remains unchanged at π*. Signup and view all the answers

What indicates that demand shocks are dominant in an economy?

Both inflation and output move in the same direction. Signup and view all the answers

What is the effect of increasing potential output on the LRAS and AD curves?

Both LRAS and AD curves shift outward. Signup and view all the answers

What does a rise in output caused by negative supply shocks typically indicate?

It indicates that inflation has fallen. Signup and view all the answers

During disinflation, what trend is observed in inflation expectations?

Inflation expectations fall from π* to a new target π**. Signup and view all the answers

The economy starts recovery only after expectations fall in line with the new ______.

target Signup and view all the answers

The size of recession is mild if SRAS is steep, but deep if SRAS is ______.

flat Signup and view all the answers

Anchored inflation expectations are important for maintaining economic ______.

stability Signup and view all the answers

Disinflation is characterized by a decrease in the rate of ______.

inflation Signup and view all the answers

A confidence slump generally leads to a leftward shift of the ______ curve.

AD Signup and view all the answers

Long-run shocks are related to trend growth in output and policy change from the ______.

central bank Signup and view all the answers

Demand shocks affect aggregate demand the same way as supply shocks affect aggregate ______.

supply Signup and view all the answers

The slope parameters within the model (α, γ, ϕ, β) relate back to intuitive economic ______.

interpretation Signup and view all the answers

During a confidence slump, output decreases from Y ∗ to ______.

Y1 Signup and view all the answers

A temporary ______ can create high energy prices, affecting the economy's inflation rate.

spike Signup and view all the answers

In the long run, inflation returns to ______ regardless of temporary shocks.

π ∗ Signup and view all the answers

When consumer confidence is low, the AD curve shifts inward, causing a decrease in ______.

consumption demand Signup and view all the answers

An increase in inflation may lead central banks to raise ______ rates.

real interest Signup and view all the answers

The long-run aggregate supply curve (LRAS) represents the potential output of an economy under ______ conditions.

ideal Signup and view all the answers

Inflation decreases from π ∗ to ______ when output is reduced during a confidence slump.

π1 Signup and view all the answers

A rise in energy prices results in a shift of the SRAS curve ______.

upward Signup and view all the answers

A temporary economic event that shifts the AD curve is known as a ______.

shock Signup and view all the answers

The AD curve represents the relationship between inflation (π) and real ______.

output Signup and view all the answers

A confidence slump typically causes a leftward shift in the ______ curve.

AD Signup and view all the answers

In the long run, the SRAS curve leads to an output level of ______.

Y* Signup and view all the answers

During an investment boom, the AD curve shifts ______ along the unchanged SRAS curve.

outward Signup and view all the answers

In the absence of shocks, inflation expectations are ______ at a stable rate.

anchored Signup and view all the answers

Shocks to components of aggregate demand shift the ______ curve.

AD Signup and view all the answers

In response to increased investment demand, output initially increases to ______.

Y1 Signup and view all the answers

The Long Run Aggregate Supply (LRAS) indicates that there is no relationship between inflation and ______.

output Signup and view all the answers

The ______ curve is upward sloping, indicating a positive relationship between inflation and output in the short run.

SRAS Signup and view all the answers

Supply shocks drive inflation and output in ______ directions.

opposite Signup and view all the answers

A positive supply shock results in inflation rising and output ______.

falls Signup and view all the answers

If the AD curve is ______, most of the response to supply shock is a change in output with little change in inflation.

flat Signup and view all the answers

Growth in potential output shifts both LRAS and ______ curves outward.

LRAD Signup and view all the answers

Disinflation occurs when the central bank sets a permanently ______ inflation target.

lower Signup and view all the answers

In response to a negative supply shock, inflation ______ and output rises.

falls Signup and view all the answers

During disinflation, inflation expectations πe fall from π* to new ______.

π** Signup and view all the answers

The relationship between inflation and output is assessed based on whether inflation and output are moving ______.

together Signup and view all the answers

Output permanently increases when Y* is ______.

higher Signup and view all the answers

If the AD curve shifts down permanently, the output decreases from Y* to ______.

Y1 Signup and view all the answers

Study Notes

AD-AS Model

The AD-AS model is used to analyze economic conditions and responses to shocks.
AD curve shows the negative relationship between inflation and output: higher inflation leads to higher real interest rates, which reduces output.
SRAS curve shows the positive relationship between inflation and output in the short run: higher inflation due to increased demand leads to lower unemployment, higher wages, and higher business costs.
LRAS curve shows no relationship between inflation and output in the long run.

Temporary Shocks

Temporary shocks can be positive or negative.
Positive shocks increase output and inflation in the short-run, while negative shocks decrease output and inflation.
Inflation expectations generally remain anchored, meaning people don't change their long-term inflation expectations based on short-term fluctuations, assuming there's confidence in central bank policy.
Examples of temporary demand shocks include investment booms and confidence slumps.
Examples of temporary supply shocks include energy price spikes.
The difference between demand and supply shocks can be identified based on whether output and inflation move in the same or opposite directions.

Permanent Shocks

Permanent shocks have lasting effects on both output and inflation.
Examples of permanent shocks include growth in potential output (Y*) and a decrease in the target inflation rate (π*).
A decrease in target inflation leads to a decrease in output temporarily, as the AD curve shifts down. Over time, as expected inflation adjusts, the SRAS curve will also shift down to match the new lower inflation target.
Changes in potential output lead to shifts in both LRAS and LRAD curves.
Changes in potential output may or may not lead to changes in inflation, depending on whether the expansion or contraction of output is caused by a short-term shift in demand due to a temporary shock or a long-term shift in potential output.

Slopes of AD and SRAS

The slope of the AD curve is influenced by the central bank's reaction coefficient (α) and sensitivity to real interest rates (γ): higher values lead to a flatter AD curve.
A flat AD curve implies larger changes in output and smaller changes in inflation in response to shocks.
The slope of the SRAS curve can be impacted by the sensitivity of wages to changes in output (β) and inflation expectations (πe).
A steeper SRAS curve implies larger changes in inflation and smaller changes in output in response to shocks.

The AD-AS Model and Economic Shocks

The AD-AS Model demonstrates the relationship between aggregate demand (AD), aggregate supply (SRAS), and long-run aggregate supply (LRAS) to explain the relationship between inflation (π) and output (Y).
AD Curve: This curve shows the inverse relationship between inflation and output, driven by the central bank's response to inflation.
Higher inflation leads to higher real interest rates, reducing investment and consumption, leading to lower output.
Shocks to AD components (like investment booms or confidence slumps) shift the AD curve.
SRAS Curve: This curve shows the upward sloping relationship between inflation and output in the short term.
It reflects the short-run Phillips Curve tradeoff between inflation and unemployment, resulting from changing wages and business costs.
LRAS Curve: This curve shows no relationship between inflation and output in the long run.
It represents the natural rate of unemployment, where inflation expectations are consistent with the inflation target (πe = π).
Temporary Shocks: These shocks are short-term and have no long-term impact on the economy.
Investment Boom: Increases AD, leading to higher output and inflation in the short term, but the economy returns to its long-run equilibrium.
Confidence Slump: Decreases AD, leading to lower output and inflation in the short term, but the economy returns to its long-run equilibrium.
Energy Price Spike: Shifts SRAS upwards, leading to higher inflation and lower output in the short term, but the economy returns to its long-run equilibrium.
Demand vs. Supply Shocks: Demand shocks impact inflation and output in the same direction, while supply shocks impact them in opposite directions.
Slope of AD and SRAS Curve: The slope of these curves determines the impact of shocks on inflation and output.
A flatter AD curve indicates a larger output response and a smaller inflation response to a given shock.
A steeper SRAS curve indicates a larger inflation response and a smaller output response to a given shock.
Permanent Shocks: These shocks have long-term impacts on the economy.
Growth in Potential Output: Shifts both LRAS and AD curves outward, leading to higher output but no immediate impact on inflation.
Disinflation: A deliberate decrease in the inflation target, shifts AD curve down, leading to lower output and inflation in the short term.
Inflation expectations must adjust downward for the economy to reach its new long-run equilibrium.

The AD-AS Model and Economic Shocks

The AD-AS model illustrates the relationship between aggregate demand (AD), aggregate supply (SRAS and LRAS), inflation (π), and output (Y).
The AD curve is downward sloping due to the inverse relationship between inflation and output, driven by the central bank's response to inflation through interest rate adjustments.
The SRAS curve is upward sloping due to the short-run Phillips Curve trade-off between inflation and unemployment, influencing output.
The LRAS curve is vertical, representing the long-run equilibrium where output is at its potential level (Y*), and inflation expectations are consistent with the target inflation rate (π*).

Temporary Shocks

Investment Boom:
- Positive demand shock (εD > 0)
- Increases output and inflation in the short run.
- Inflation expectations remain anchored, meaning individuals and firms maintain their long-term inflation beliefs despite the short-term increase in inflation.
- Long-run equilibrium remains unchanged, with output and inflation returning to their original levels as investment returns to its trend.
Confidence Slump:
- Negative demand shock (εD < 0)
- Reduces output and inflation in the short run.
- Inflation expectations remain anchored.
- Output and inflation return to their original levels in the long run.
Energy Price Hike:
- Positive supply shock (εS > 0)
- Decreases output and increases inflation in the short run, as the central bank raises interest rates to combat inflation, reducing investment and consumption.
- Long-run equilibrium remains unchanged, with output and inflation returning to original levels as energy prices revert to their long-term trend.

Permanent Shocks

Growth in Potential Output:
- Permanent increase in potential output (Y*).
- Shifts both the LRAS and LRAD curves outwards, leading to increased output without affecting inflation.
Disinflation:
- Permanent decrease in the inflation target (π*).
- Shifts the AD curve down, reducing output and inflation in the short run.
- Over time, inflation expectations adjust, represented by a downward shift in the SRAS curve, resulting in a new long-run equilibrium with lower inflation and potential output.

Slope of the AD and SRAS Curves

Slope of AD Curve:
- Determines the magnitude of the response to various shocks.
- A flatter AD curve implies a larger response in output and a smaller response in inflation, given a certain shock size.
- A steeper AD curve indicates a smaller response in output and a larger response in inflation.
Impact of the Central Bank’s Reaction Coefficient (α):
- A higher α indicates a more aggressive response by the central bank to inflation, leading to a flatter AD curve.
- A lower α suggests a less aggressive response, resulting in a steeper AD curve.

Key Takeaways

The AD-AS model is a useful tool for understanding the impact of various economic shocks on inflation and output.
Temporary shocks generally have short-term effects on output and inflation, with the economy eventually returning to its long-run equilibrium.
Permanent shocks, such as changes in potential output and inflation targets, can have more persistent effects on the economy.
The slopes of the AD and SRAS curves influence the magnitude of responses to shocks, with a flatter AD and SRAS curve leading to larger changes in output and smaller changes in inflation, and vice versa.

Aggregate Demand Curve

The AD Curve shows the relationship between inflation (π) and output (Y) and is downward sloping.
Higher inflation leads the central bank to increase real interest rates, and higher real interest rates decrease output.
Shifts to the AD curve are caused by shocks to components of aggregate demand.
A higher central bank reaction coefficient (α) indicates a more aggressive response and creates a flatter AD curve.

Aggregate Supply Curve

The SRAS Curve shows the relationship between inflation (π) and output (Y) and is upward sloping.
The LRAS Curve shows that in the long run there is no relationship between inflation (π) and output (Y).
The short-run Phillips Curve tradeoff exists in the short run but in the long run inflation expectations are consistent (π e = π), the natural rate hypothesis holds (u = u*), and output is equal to potential output(Y = Y*).
Shifts to the SRAS curve are caused by shocks (εS).

Types of Shocks

Temporary Shock: Changes in economic conditions that last for a short period, such as an investment boom, confidence slump, or energy price hike.
Permanent Shock: Changes in economic conditions that last for a long period, such as an increase in potential output or a decrease in the inflation target.

Investment Boom

Causes the AD curve to shift outwards along the SRAS curve.
Increases output and inflation, but inflation expectations remain anchored.
Long run equilibrium is unchanged, and output and inflation will return to the initial levels.

Confidence Slump

Causes the AD curve to shift inwards along the SRAS curve.
Decreases output and inflation, but inflation expectations remain anchored.
Long run equilibrium is unchanged, and output and inflation will return to the initial levels.

Energy Price Spike

Causes the SRAS curve to shift upwards along the AD curve.
Decreases output and increases inflation, but inflation expectations remain anchored.
Long run equilibrium is unchanged, and output and inflation will return to the initial levels.

Demand vs. Supply Shocks

Demand Shocks: Drive inflation and output in the same direction. They are a result of changes in consumer or business spending.
Supply Shocks: Drive inflation and output in opposite directions. They are a result of changes in production costs or available resources.

Flat AD Curve

If the AD curve is flat (α or γ is high) then the majority of the response to a supply shock will be a change in output with little change in inflation.

Growth in Potential Output

Causes shifts in the LRAS and the LRAD curves outwards.
Increases output but has no effect on inflation.
Growth in output does not necessarily lead to higher inflation.

Disinflation

A reduction in the inflation target leads to a permanent downward shift in the AD curve along the SRAS curve, decreasing output and inflation.
Inflation expectations fall over time, eventually a new long run equilibrium is established where output is back to the long run potential and inflation is lower.

Slope of the demand curve

The slope of the AD curve is inversely proportional to the α and γ parameters. This means that a higher α (more aggressive central bank response to inflation) or a higher γ (the responsiveness of output to changes in the real interest rate) will lead to a flatter AD curve.

Essentially, the text describes the dynamics of the AD-AS model, exploring the impact of different types of shocks on the economy in both the short run and the long run. It highlights the importance of anchored inflation expectations in maintaining economic stability, as well as the role of the central bank in responding to inflation.

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Description

Explore the AD-AS model, which analyzes economic conditions and the impact of temporary shocks. Understand the relationships of the AD curve, SRAS curve, and LRAS curve in influencing output and inflation both short-term and long-term.