Aggregate Demand and Real Interest Rates
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Questions and Answers

How does a higher real interest rate affect consumption according to the consumption function?

  • It decreases consumption by making borrowing more expensive. (correct)
  • It has no effect on consumption.
  • It increases consumption due to lower borrowing costs.
  • It increases consumption because of higher savings returns.

    • What does the parameter γI indicate in the investment function?

  • The interest-sensitivity of consumption.
  • The baseline investment demand.
  • The sensitivity of investment to changes in the real interest rate. (correct)
  • The level of aggregate income.

    • Which of the following statements about output Y and real interest rate r is true?

  • As the real interest rate increases, output Y increases.
  • Output Y decreases as real interest rate r increases. (correct)
  • Higher output Y leads to an increase in the real interest rate.
  • Output Y is independent of the real interest rate.

    • What is represented by the term A in the output equation?

    <p>The net effect of aggregate demand components. (D)</p> Signup and view all the answers

    In the context of the extended Keynesian model, what happens when real interest rate r is raised?

    <p>Investment demand decreases. (B)</p> Signup and view all the answers

    Which of the following factors could contribute to a shock to aggregate demand?

    <p>Shifts in consumer sentiment. (D)</p> Signup and view all the answers

    How is the natural output Y* related to the natural real rate r*?

    <p>Y* equals A* minus γ times r*. (B)</p> Signup and view all the answers

    What does the equation Y - Y* = -γ(r - r*) + εD represent?

    <p>The gap between actual and natural output due to interest rate differentials. (C)</p> Signup and view all the answers

    What does the AS curve primarily reflect in the short run?

    <p>The relationship between inflation and output based on expectations. (A)</p> Signup and view all the answers

    According to the natural rate hypothesis, in the long run, the economy gravitates towards which of the following?

    <p>The natural rate of output regardless of inflation expectations. (A)</p> Signup and view all the answers

    What is the primary factor that differentiates the short run AS curve from the long run AS curve?

    <p>The role of inflation expectations and price rigidity. (B)</p> Signup and view all the answers

    In the context of Okun's Law, what does a decrease in the unemployment rate typically indicate?

    <p>A corresponding increase in output relative to potential output. (A)</p> Signup and view all the answers

    Which of the following formulas represents the Aggregate Demand relation as per the content?

    <p>Y − Y ∗ = −αγ (π − π ∗ ) + εD (B)</p> Signup and view all the answers

    What is the relationship between inflation ($\pi$) and real output (Y) according to the AD curve?

    <p>Downward sloping relationship (C)</p> Signup and view all the answers

    Which factor primarily determines the position of the AD curve?

    <p>Monetary and fiscal policy (A)</p> Signup and view all the answers

    How does an increase in inflation ($\pi$) affect real interest rates ($r$) according to the monetary policy reaction function?

    <p>Real interest rates increase (A)</p> Signup and view all the answers

    What role do inflation expectations play in the AS curve?

    <p>They determine the position of the AS curve (D)</p> Signup and view all the answers

    According to Okun's Law, a relationship exists between which two economic indicators?

    <p>Real output and unemployment (B)</p> Signup and view all the answers

    What does an upward sloping relationship in the AS curve indicate?

    <p>As output (Y) increases, inflation ($ enewcommand{ }{r}$) increases (B)</p> Signup and view all the answers

    In the short-run equilibrium output formula, what components determine output (Y)?

    <p>Consumption (C), Investment (I), Government spending (G) (D)</p> Signup and view all the answers

    What effect does an increase in real interest rates ($r$) typically have on aggregate output (Y)?

    <p>Aggregate output decreases (B)</p> Signup and view all the answers

    What happens to the policy interest rate when inflation increases above the central bank's target?

    <p>It increases. (B)</p> Signup and view all the answers

    How is the real interest rate related to the nominal interest rate and inflation?

    <p>Real rate is the difference between nominal rate and inflation. (C)</p> Signup and view all the answers

    What does a downward sloping AD curve indicate regarding the relationship between inflation and output?

    <p>Higher inflation corresponds to lower output. (B)</p> Signup and view all the answers

    According to the Phillips Curve, what happens when unemployment decreases?

    <p>Inflation increases. (B)</p> Signup and view all the answers

    In the long run, what is the relationship between inflation and unemployment according to the Natural Rate Hypothesis?

    <p>There is no trade-off; unemployment returns to the natural rate. (B)</p> Signup and view all the answers

    What does the AS curve represent in terms of the relationship between inflation and output?

    <p>An upward sloping relationship. (B)</p> Signup and view all the answers

    In the context of Okun's Law, what happens to cyclical unemployment when there is an output increase?

    <p>Cyclical unemployment decreases. (C)</p> Signup and view all the answers

    What variable in the AD curve represents the sensitivity of the central bank's policy rate to the inflation gap?

    <p>α (D)</p> Signup and view all the answers

    What characterizes the Long Run Aggregate Supply (LRAS) curve?

    <p>It is vertical at natural output level Y*. (B)</p> Signup and view all the answers

    In a short run equilibrium, what is treated as exogenous?

    <p>Inflation expectations. (D)</p> Signup and view all the answers

    What happens to inflation expectations in the long run if the economy is at the natural rate of unemployment?

    <p>Expectations align with actual inflation. (B)</p> Signup and view all the answers

    What will occur to output when both demand and supply shocks equal zero?

    <p>Output will be at natural output level Y*. (B)</p> Signup and view all the answers

    Which condition is necessary for the short-run AS curve to shift?

    <p>A change in inflation expectations. (A)</p> Signup and view all the answers

    What effect does a negative demand shock have on the AD curve?

    <p>It shifts the AD curve to the left. (B)</p> Signup and view all the answers

    Higher real interest rates tend to increase consumption due to reduced cost of borrowing.

    <p>False (B)</p> Signup and view all the answers

    The parameter γC indicates the interest-sensitivity of consumption.

    <p>True (A)</p> Signup and view all the answers

    Investment demand decreases with a rise in the real interest rate because fewer projects become profitable.

    <p>True (A)</p> Signup and view all the answers

    The equation Y = A - γr suggests that output Y is positively related to the real interest rate r.

    <p>False (B)</p> Signup and view all the answers

    The natural output Y* can be expressed in terms of the natural real rate r*.

    <p>True (A)</p> Signup and view all the answers

    When aggregate demand shocks occur, they shift the components of A away from long run levels A*.

    <p>True (A)</p> Signup and view all the answers

    The extended Keynesian model shows that Y is independent of consumption and investment.

    <p>False (B)</p> Signup and view all the answers

    A decrease in the parameter γI would lead to an increase in the interest sensitivity of investment demand.

    <p>False (B)</p> Signup and view all the answers

    The AD curve has a downward sloping relationship between inflation π and output Y.

    <p>True (A)</p> Signup and view all the answers

    The AS curve has a downward sloping relationship between inflation π and output Y.

    <p>False (B)</p> Signup and view all the answers

    According to the extended Keynesian model, real interest rates have no effect on output Y.

    <p>False (B)</p> Signup and view all the answers

    Inflation expectations play a critical role in determining the position of the AS curve.

    <p>True (A)</p> Signup and view all the answers

    In the AD-AS model, the intersection of the AD and AS curves determines the equilibrium levels of output and inflation.

    <p>True (A)</p> Signup and view all the answers

    The relationship between output Y and real interest rates r is negative in the AD framework.

    <p>True (A)</p> Signup and view all the answers

    Okun's Law states that there is no relationship between unemployment and output.

    <p>False (B)</p> Signup and view all the answers

    Supply shocks have no impact on the AS curve's position.

    <p>False (B)</p> Signup and view all the answers

    The short-run aggregate supply (AS) curve is influenced by inflation expectations.

    <p>True (A)</p> Signup and view all the answers

    Okun’s Law suggests that a decrease in the unemployment rate is associated with an increase in output.

    <p>True (A)</p> Signup and view all the answers

    In the AD-AS model, permanent shocks always lead to a shift in the aggregate supply curve.

    <p>False (B)</p> Signup and view all the answers

    The equation $Y - Y^* = - heta( rac{r - r^*}{ ho}) + u_D$ represents aggregate demand.

    <p>False (B)</p> Signup and view all the answers

    The natural rate hypothesis implies that, in the long run, output is determined solely by the natural rate of unemployment.

    <p>True (A)</p> Signup and view all the answers

    The policy interest rate is increased when inflation is below the central bank's target.

    <p>False (B)</p> Signup and view all the answers

    When inflation is at its target level, the real interest rate equals the natural real rate.

    <p>True (A)</p> Signup and view all the answers

    The AD curve has a downward sloping relationship between the quantity of output and inflation.

    <p>True (A)</p> Signup and view all the answers

    The Phillips Curve indicates a direct relationship between unemployment and inflation.

    <p>False (B)</p> Signup and view all the answers

    According to Okun's Law, an increase in output leads to a decrease in unemployment.

    <p>True (A)</p> Signup and view all the answers

    The Long Run Aggregate Supply (LRAS) curve is typically represented as upward sloping.

    <p>False (B)</p> Signup and view all the answers

    The slope of the AD curve is determined by the sensitivity of the central bank’s policy rate to the inflation gap.

    <p>True (A)</p> Signup and view all the answers

    Inflation expectations are fixed in the long run according to the Natural Rate Hypothesis.

    <p>True (A)</p> Signup and view all the answers

    In the case of supply shocks, the AS curve shifts leftward, indicating an increase in output.

    <p>False (B)</p> Signup and view all the answers

    In the short run, an increase in nominal interest rates results in a decrease in the real interest rate.

    <p>False (B)</p> Signup and view all the answers

    The equation $Y - Y^* = -eta(u - u^*)$ defines the AD curve.

    <p>False (B)</p> Signup and view all the answers

    When demand and supply shocks equal zero, the economy is considered to be in long run equilibrium.

    <p>True (A)</p> Signup and view all the answers

    A tighter labor market decreases wages and therefore decreases prices.

    <p>False (B)</p> Signup and view all the answers

    In the SRAS curve, the output (Y) can be treated as exogenous.

    <p>False (B)</p> Signup and view all the answers

    How does the AD curve illustrate the relationship between inflation and output?

    <p>The AD curve represents a downward sloping relationship between inflation ($\pi$) and output (Y), indicating that as inflation increases, the output decreases.</p> Signup and view all the answers

    What are the two main components that determine the position of the AD curve?

    <p>The position of the AD curve is determined by the relationship between output (Y) and real interest rates (r), and the relationship between inflation ($\pi$) and real interest rates (r).</p> Signup and view all the answers

    Explain how inflation expectations affect the AS curve.

    <p>Inflation expectations influence the AS curve by determining its position; if expectations rise, the AS curve shifts upward, resulting in higher inflation at any level of output.</p> Signup and view all the answers

    What is the significance of Okun's Law in relation to output and unemployment?

    <p>Okun's Law indicates that a decrease in the unemployment rate is typically associated with an increase in output, demonstrating the inverse relationship between these two variables.</p> Signup and view all the answers

    What role do demand shocks play in shifting the AD curve?

    <p>Demand shocks impact the AD curve by shifting it either to the right or left, reflecting unexpected changes in consumer or business spending behaviors.</p> Signup and view all the answers

    Describe how the AS curve differs from the AD curve in terms of their slopes.

    <p>The AS curve has an upward sloping relationship between inflation ($\pi$) and output (Y), while the AD curve has a downward sloping relationship, indicating differing economic influences on these variables.</p> Signup and view all the answers

    What happens to equilibrium levels of output and inflation at the intersection of the AD and AS curves?

    <p>At the intersection of the AD and AS curves, the economy finds its equilibrium levels of output (Y) and inflation ($\pi$), balancing aggregate demand with aggregate supply.</p> Signup and view all the answers

    In the context of the extended Keynesian model, what is the importance of real interest rates?

    <p>In the extended Keynesian model, real interest rates play a crucial role by influencing both consumption and investment decisions, which in turn affect aggregate output (Y).</p> Signup and view all the answers

    How does the parameter γC influence consumption when real interest rates rise?

    <p>The parameter γC, being positive, indicates that higher real interest rates decrease consumption by making borrowing more costly and increasing the return on savings.</p> Signup and view all the answers

    What is the relationship between output Y and real interest rate r in the model?

    <p>Output Y is negatively related to the real interest rate r, as indicated by the equation Y = A - γr, where γ reflects the interest sensitivity of output.</p> Signup and view all the answers

    In the context of the extended Keynesian model, what does the variable A represent?

    <p>Variable A represents the exogenous aggregate demand components, calculated as $A = \frac{C̄ - cT̄ + Ī + Ḡ}{1 - c}$.</p> Signup and view all the answers

    How does a change in the real interest rate r affect investment I according to the investment function?

    <p>An increase in the real interest rate r reduces investment I, as it is expressed by the equation $I = Ī - γI r$, making fewer investment projects profitable.</p> Signup and view all the answers

    What role do aggregate demand shocks εD play in the relationship between actual output Y and natural output Y*?

    <p>Aggregate demand shocks εD shift actual output Y away from natural output Y*, indicating deviations from long-run levels due to changes in demand components.</p> Signup and view all the answers

    What does the equation Y - Y* = -γ(r - r*) + εD signify in the economic model?

    <p>This equation represents the gap between actual output Y and natural output Y*, showing how deviations are influenced by the differences in real interest rates and aggregate demand shocks.</p> Signup and view all the answers

    How does an increase in γI affect the sensitivity of investment to changes in real interest rates?

    <p>An increase in γI suggests that investment demand becomes more sensitive to real interest rate changes, leading to greater reductions in investment when rates rise.</p> Signup and view all the answers

    Explain how the formula for natural output Y* relates to the natural real rate r*.

    <p>The natural output Y* is expressed as $Y^* = A^* - γr^*$, indicating that it reflects long-run output levels adjusted for natural real interest rates.</p> Signup and view all the answers

    What role do inflation expectations play in the short-run Aggregate Supply (AS) curve?

    <p>Inflation expectations shift the AS curve; when expectations rise, firms increase prices, leading to higher actual inflation.</p> Signup and view all the answers

    How does Okun's Law articulate the relationship between unemployment and output in the short run?

    <p>Okun's Law suggests that for every 1% decrease in the unemployment rate, a country's GDP will be roughly an additional 2% higher than its potential GDP.</p> Signup and view all the answers

    What differentiates the short-run Aggregate Supply curve from the long-run Aggregate Supply curve?

    <p>The short-run AS curve is influenced by real costs and inflation expectations, while the long-run AS curve is vertical, indicating full employment regardless of price levels.</p> Signup and view all the answers

    What is the significance of the natural rate hypothesis in understanding the AS curve over a long period?

    <p>The natural rate hypothesis asserts that in the long run, the economy will return to a steady state of unemployment and output, unaffected by inflation.</p> Signup and view all the answers

    How do shocks to aggregate demand or supply affect the equilibrium in the AD-AS model?

    <p>Shocks shift the AD or AS curves, altering the equilibrium price level and output, leading to potential inflation or recession.</p> Signup and view all the answers

    What happens to the real interest rate when inflation rises and is above the central bank's target?

    <p>The real interest rate increases as the central bank raises the nominal interest rate to combat inflation.</p> Signup and view all the answers

    Explain the relationship between inflation and unemployment as described by the Phillips Curve.

    <p>The Phillips Curve indicates that a decrease in unemployment typically leads to an increase in inflation.</p> Signup and view all the answers

    How does the slope of the AD curve relate to the parameters α and γ?

    <p>The slope of the AD curve is given by $-αγ$, showing the negative relationship between inflation and output.</p> Signup and view all the answers

    According to Okun's Law, what happens to unemployment when there is an increase in output?

    <p>As output increases, unemployment decreases, reflecting the inverse relationship stated by Okun's Law.</p> Signup and view all the answers

    What does the Long Run Aggregate Supply (LRAS) curve indicate about the economy's output?

    <p>The LRAS curve is vertical at $Y^*$, indicating that in the long run, output is determined by factors other than price level.</p> Signup and view all the answers

    What role do supply shocks play in the Aggregate Supply (AS) curve?

    <p>Supply shocks can shift the AS curve and affect the relationship between inflation and output, represented in the AS equation.</p> Signup and view all the answers

    Describe the significance of the natural rate hypothesis in the context of the Phillips Curve.

    <p>The natural rate hypothesis asserts that in the long run, inflation expectations align with actual inflation, leading to no trade-off between inflation and unemployment.</p> Signup and view all the answers

    How does a negative demand shock affect the AD curve?

    <p>A negative demand shock shifts the AD curve to the left, indicating a decrease in output at a given price level.</p> Signup and view all the answers

    In the context of aggregate demand, what does εD represent?

    <p>In the AD equation, $ ext{εD}$ represents demand shocks that can lead to deviations from the expected output level.</p> Signup and view all the answers

    What can lead to a shift in expectation regarding inflation in the AS curve?

    <p>Changes in expected future inflation can shift the AS curve by altering the cost structure faced by producers.</p> Signup and view all the answers

    How does the inverse relationship in Okun's Law connect unemployment and the output gap?

    <p>Okun's Law states that a decrease in the output gap corresponds to a decrease in unemployment.</p> Signup and view all the answers

    What is the mathematical representation of the Phillips Curve?

    <p>The Phillips Curve is represented as $ ext{π} = ext{π}^e - ϕ(u - u^*) + ε_s$.</p> Signup and view all the answers

    What condition is necessary for the short-run AD curve to align with the long-run equilibrium?

    <p>For the short-run AD curve to align with long-run equilibrium, demand and supply shocks must equal zero, $ ext{εD} = ext{εS} = 0$.</p> Signup and view all the answers

    What happens to inflation expectations when the economy stabilizes at the natural rate of unemployment?

    <p>When the economy is at the natural rate of unemployment, inflation expectations become consistent with actual inflation.</p> Signup and view all the answers

    How do inflation expectations influence the short-run aggregate supply (SRAS) curve?

    <p>Inflation expectations play a critical role in determining the position of the SRAS curve, as they are taken as exogenous.</p> Signup and view all the answers

    The AS curve differs in the short run and the long run primarily due to the role of ______ expectations.

    <p>inflation</p> Signup and view all the answers

    According to Okun's Law, a decrease in the ______ rate typically suggests an increase in output.

    <p>unemployment</p> Signup and view all the answers

    The equation Y - Y* = -αγ(π - π*) + ______ represents the Aggregate Demand.

    <p>εD</p> Signup and view all the answers

    In a short-run equilibrium, the output is treated as ______.

    <p>exogenous</p> Signup and view all the answers

    The sensitivity of policy rate to the ______ gap is represented by α in the monetary policy rule.

    <p>inflation</p> Signup and view all the answers

    Higher real interest rates lead to a decrease in investment demand due to higher cost of ______.

    <p>borrowing</p> Signup and view all the answers

    In the equation Y = A - γr, the term A represents exogenous aggregate ______ components.

    <p>demand</p> Signup and view all the answers

    The parameter γC indicates the interest-sensitivity of ______.

    <p>consumption</p> Signup and view all the answers

    Output Y is ______ in real interest rate r according to the extended Keynesian model.

    <p>decreasing</p> Signup and view all the answers

    The equation Y - Y* = -γ(r - r*) + εD represents the relationship between output and the natural ______ rate.

    <p>real</p> Signup and view all the answers

    A higher interest rate increases the opportunity cost of ______, discouraging investment.

    <p>investment</p> Signup and view all the answers

    The parameter γI measures interest-sensitivity of ______.

    <p>investment</p> Signup and view all the answers

    Shocks to aggregate demand can represent anything that shifts components of A away from long-run ______ levels.

    <p>normative</p> Signup and view all the answers

    Central banks increase interest rates in response to ______.

    <p>inflation</p> Signup and view all the answers

    In the equation for the monetary policy reaction function, 'i' stands for the policy interest rate and 'r*' represents the natural ______ rate.

    <p>real</p> Signup and view all the answers

    The AD curve demonstrates a downward sloping relationship between ______ and output Y.

    <p>inflation</p> Signup and view all the answers

    According to the Phillips Curve, as unemployment ______, inflation increases.

    <p>decreases</p> Signup and view all the answers

    The AS curve shows an upward sloping relationship between ______ and output Y, holding inflation expectations fixed.

    <p>inflation</p> Signup and view all the answers

    The AD-AS model analyzes the interaction between aggregate demand and aggregate ______.

    <p>supply</p> Signup and view all the answers

    In the long run, the Phillips Curve is vertical at the natural rate of ______.

    <p>unemployment</p> Signup and view all the answers

    The AD curve has a downward sloping relationship between inflation (π) and real ______.

    <p>output</p> Signup and view all the answers

    Okun's Law expresses a relationship between the output gap and cyclical ______.

    <p>unemployment</p> Signup and view all the answers

    In the AS curve, the position is determined by inflation expectations and supply ______.

    <p>shocks</p> Signup and view all the answers

    The Phillips Curve demonstrates an inverse relationship between inflation and ______.

    <p>unemployment</p> Signup and view all the answers

    The short-run aggregate supply (SRAS) curve is positively sloped due to the upward relationship between ______ and output.

    <p>inflation</p> Signup and view all the answers

    When output Y is equal to the natural level Y*, unemployment is said to be at its ______ rate.

    <p>natural</p> Signup and view all the answers

    Aggregate Demand can be expressed as Y = C + I + ______.

    <p>G</p> Signup and view all the answers

    In long-run equilibrium, both demand and supply shocks are equal to ______.

    <p>zero</p> Signup and view all the answers

    The AD-AS model demonstrates that the intersection of the AD and AS curves determines equilibrium levels of inflation and ______.

    <p>output</p> Signup and view all the answers

    Inflation expectations are treated as ______ in the short-run equilibrium framework.

    <p>exogenous</p> Signup and view all the answers

    According to the extended Keynesian model, when real interest rates rise, it typically leads to a ______ in aggregate output.

    <p>decrease</p> Signup and view all the answers

    Okun’s Law describes the relationship between unemployment and ______.

    <p>output</p> Signup and view all the answers

    The relationship between output Y and real interest rates can be characterized as ______ in the AD framework.

    <p>negative</p> Signup and view all the answers

    The term ‘εD’ in the AD curve equation captures the effects of ______ on aggregate demand.

    <p>shocks</p> Signup and view all the answers

    The natural rate hypothesis claims that in the long run, the economy gravitates towards the natural rate of ______.

    <p>unemployment</p> Signup and view all the answers

    Study Notes

    Aggregate Demand (AD)

    • The AD curve shows the negative relationship between inflation (π) and real output (Y).
    • The AD curve is determined by monetary and fiscal policy, and demand shocks.
    • The AD curve can be derived from the relationship between output and real interest rates (r) and the monetary policy reaction function.

    AD: Relationship between Output & Real Interest Rates

    • An extended version of the Keynesian model is used to show the negative relationship between output and real interest rates.
    • Higher real interest rates (r) reduce consumption and investment due to inter-temporal tradeoffs, higher cost of borrowing, and opportunity costs.

    AD: Monetary Policy Reaction Function

    • The central bank sets the policy interest rate (i) to respond to inflation (π).
    • The monetary policy reaction function shows the positive relationship between the real interest rate (r) and inflation (π) based on:
      • Natural real rate (r*)
      • Central bank inflation target (π*)
      • Sensitivity of the central bank's policy rate to the inflation gap (α)
    • When inflation is at the target (π = π*), the real rate (r) equals the natural real rate (r*).
    • The monetary policy reaction function and the relationship between output and real interest rates are combined to derive the AD curve.
    • The AD curve shows the negative relationship between output (Y) and inflation (π) with a slope of αγ.

    Aggregate Supply (AS)

    • The AS curve shows the positive relationship between inflation (π) and real output (Y) holding inflation expectations fixed.
    • The AS curve is determined by the relationship between unemployment and inflation (from the Phillips Curve) and the relationship between unemployment and real output (from Okun's Law).
    • The AS curve is different in the short run and long run.

    AS: Short Run

    • The short-run AS (SRAS) curve is derived from the Phillips Curve and Okun's Law.
    • Holding inflation expectations fixed, an increase in output leads to a decrease in unemployment, and an increase in inflation.
    • The SRAS has an upward sloping relationship between output and inflation, with a slope of ϕβ.

    AS: Long Run

    • The long-run AS (LRAS) curve is vertical at the natural output level (Y*).
    • In the long run, the natural rate of unemployment (u*) prevails, and there is no trade-off between inflation and unemployment.

    Equilibrium in the AD-AS Model

    • In the long-run equilibrium, demand and supply shocks are zero (€D=€S= 0), and inflation expectations are consistent with realized inflation (πe= π).
    • The AD and AS curves intersect at the natural output level (Y*), and the inflation rate equals the central bank inflation target (π*).
    • In the short-run equilibrium, the AD and AS curves intersect at a specific level of output and inflation determined by the current values of inflation expectations (πe), demand shocks (€D), and supply shocks (€S).
    • Short-run changes in inflation expectations (πe), demand shocks (€D), or supply shocks (€S) can shift the AD and SRAS curves in the short run, resulting in changes in output (Y) and inflation (π).

    The AD-AS Model I

    • The AD-AS model is a framework for analyzing monetary and fiscal policy.
    • It uses two endogenous variables: inflation (π) and real output (Y).
    • The AD curve is downward sloping, showing the relationship between π and Y.
    • The position of the AD curve is determined by monetary and fiscal policy and demand shocks.
    • The AS curve is upward sloping, showing the relationship between π and Y.
    • The position of the AS curve is determined by inflation expectations and supply shocks.
    • The intersection of the two curves determines the equilibrium π and Y.
    • The extended Keynesian model includes a role for interest rates.

    Aggregate Demand

    • The AD curve shows the downward sloping relationship between π and Y.
    • Two components determine the relationship:
      • The relationship between output Y and real interest rates r (from the extended version of the Keynesian model).
      • The relationship between inflation π and real interest rates r (from the monetary policy reaction function).
    • Higher π leads to higher r, which leads to lower Y.

    Consumption and Real Interest Rate

    • The consumption function is extended to include the real interest rate.
    • Higher r reduces consumption and increases saving, making borrowing more expensive and increasing the returns to savings.

    Investment and Real Interest Rate

    • The investment function is also extended to include the real interest rate.
    • Higher r reduces investment demand as fewer projects are profitable due to the higher cost of borrowing and the higher opportunity cost of investment.

    Output and Real Interest Rate

    • Output Y is decreasing in the real interest rate r.
    • Shocks to aggregate demand (εD) affect output.
    • Shifts in components of A away from long-run levels A∗ (fiscal policy, investment demand, consumer sentiment) are examples of aggregate demand shocks.

    Monetary Policy Reaction Function

    • The central bank increases interest rates in response to inflation.
    • The monetary policy reaction function describes this relationship.
    • When inflation is at the target π = π∗, the real rate r = r∗.

    Aggregate Supply

    • The AS curve shows the upward sloping relationship between π and Y, holding inflation expectations fixed.
    • Two components determine the relationship:
      • The relationship between unemployment u and inflation π (from the Phillips Curve, natural rate hypothesis).
      • The relationship between unemployment u and real output Y (from Okun's Law).
    • Higher Y leads to lower u, which leads to higher π.

    Phillips Curve

    • The Phillips curve shows the short-run tradeoff between inflation and unemployment.
    • Higher labor market tightness (lower u) results in higher wages and prices.

    Natural Rate Hypothesis

    • In the long run, πe = π and εS = 0.
    • The long run Phillips Curve is vertical at u = u∗.
    • Long run unemployment is u∗, and inflation is indeterminate.
    • There is no long-run tradeoff between inflation and unemployment.

    Okun’s Law

    • The inverse relationship between the output gap and cyclical unemployment.
    • Unemployment u = u∗ when output Y = Y∗.

    AD-AS Equilibrium

    • Long run equilibrium occurs when:
      • demand and supply shocks are zero (εD = εS = 0)
      • inflation expectations are consistent (πe = π)
    • Short run equilibrium occurs when:
      • demand and supply shocks are present (εD, εS)
      • inflation expectations πe are treated as exogenous
    • Short run equilibrium solves Y and π in terms of πe, εD, εS, and parameters.
    • The AD-AS model can be used to analyze temporary and permanent shocks:
      • Temporary: investment boom, confidence slump, energy price hike
      • Permanent: increase in natural output, decrease in inflation target.

    New Formula(s) and Notation

    • Monetary policy rule: i = r∗ + π + α(π − π∗)
    • Aggregate demand: Y − Y∗ = −αγ(π − π∗) + εD
    • Aggregate supply: π = πe + ϕβ(Y − Y∗) + εS
    • Notation:
      • r∗: natural real rate
      • α: sensitivity of policy rate to inflation gap
      • γ: sensitivity of expenditure to interest
      • ε: εD demand shock, εS supply shock
      • ϕ: sensitivity of inflation to output gap
      • πe : inflation expectations
      • π∗: central bank inflation target

    The AD-AS Model

    • The AD-AS model is a framework for understanding the relationship between inflation (π) and output (Y), taking into account both aggregate demand (AD) and aggregate supply (AS).

    • The AD curve is downward sloping, showing that as inflation increases, output decreases. This relationship is driven by the impact of higher interest rates (r) on consumption (C) and investment (I).

    • The AS curve is upward sloping, showing that as output increases, inflation increases. This relationship is based on the Phillips Curve, which shows the inverse relationship between unemployment (u) and inflation, and Okun's Law, which connects output gap to cyclical unemployment.

    Aggregate Demand (AD)

    • AD Curve: The AD curve shows the relationship between π and Y, with its position determined by monetary and fiscal policy, and demand shocks.

    • AD Curve Determinants:

      • Interest Rates and Real Output: The relationship between output (Y) and real interest rates (r) is defined by the extended version of the Keynesian model, which includes interest sensitivity of consumption (γC) and investment (γI).
      • Monetary Policy Reaction Function: The relationship between inflation (π) and real interest rates (r) is defined by the monetary policy reaction function, where the central bank increases interest rates in response to inflation.

    Aggregate Supply (AS)

    • AS Curve: The AS curve shows the relationship between π and Y, with its position determined by inflation expectations and supply shocks.

    • AS Curve Determinants:

      • Phillips Curve: The short-run tradeoff between inflation (π) and unemployment (u) is described by the Phillips Curve, which includes inflation expectations (πe), inflation sensitivity to unemployment (ϕ), and supply shocks (εS).
      • Okun's Law: The inverse relationship between output gap and cyclical unemployment is expressed by Okun's Law, which uses a parameter (β) to quantify the relationship.

    Short Run vs. Long Run

    • Short-Run Equilibrium: The short-run equilibrium is determined by the intersection of the short-run AS (SRAS) and SRAD curves and is influenced by inflation expectations (πe), demand shocks (εD), and supply shocks (εS).
    • Long-Run Equilibrium: The long-run equilibrium is determined by the intersection of the long-run AS (LRAS) and LRAD curves. In the long run, inflation expectations are consistent (πe = π), and shocks are absent (εD = εS = 0).

    Key Formulas

    • Monetary Policy Rule: This determines the policy interest rate (i) based on the natural real rate (r*), inflation (π), inflation gap (π − π*), and the sensitivity of policy rates to inflation gap (α).
    • Aggregate Demand: This shows the relationship between output gap (Y − Y*), inflation gap (π − π*), demand shocks (εD), interest sensitivity of output (γ), and sensitivity of policy rate to inflation gap (α).
    • Aggregate Supply: This shows the relationship between inflation (π), inflation expectations (πe), output gap (Y − Y*), supply shocks (εS), inflation sensitivity to unemployment (ϕ), and sensitivity of unemployment to output gap (β).

    Learning Outcomes

    • Analyze the determinants of the AD curve, considering behavior in response to changes in real interest rates and the monetary policy reaction function.
    • Analyze the determinants of the AS curve, considering the Phillips Curve and Okun's Law.
    • Explain the differences between the AS curve in the short run and long run, focusing on inflation expectations and the natural rate hypothesis.
    • Derive AD and AS curves mathematically.
    • Understand equilibrium diagrams for the AD-AS model in both short-run and long-run scenarios.

    Aggregate Demand (AD)

    • The AD curve depicts a downward sloping relationship between inflation (π) and real output (Y).
    • AD is determined by monetary and fiscal policy, and demand shocks.
    • The AD curve is composed of two key relationships:
      • Relationship between output (Y) and real interest rates (r): Higher real interest rates lead to lower consumption and investment, resulting in reduced output.
      • Relationship between inflation (π) and real interest rates (r): The monetary policy reaction function dictates that the central bank responds to higher inflation by increasing real interest rates which in turn reduces output.

    Aggregate Supply (AS)

    • The AS curve illustrates an upward sloping relationship between inflation (π) and real output (Y) while holding inflation expectations constant.
    • AS is determined by inflation expectations and supply shocks.
    • The AS curve is also composed of two key relationships:
      • Relationship between unemployment (u) and inflation (π): The Phillips Curve suggests that lower unemployment leads to higher inflation.
      • Relationship between unemployment (u) and real output (Y): Okun's Law indicates that a higher output gap (difference between actual and potential output) leads to lower cyclical unemployment (deviation of unemployment from its natural rate).

    Short Run vs Long Run Equilibrium

    • Short Run Equilibrium: Characterized by the intersection of the short-run aggregate demand (SRAD) and short-run aggregate supply (SRAS) curves.
      • SRAD incorporates demand shocks (εD)
      • SRAS incorporates supply shocks (εS) and takes inflation expectations (πe) as given.
      • Fluctuations in output and inflation are driven by temporary shocks and fixed inflation expectations.
    • Long Run Equilibrium: Characterized by the intersection of the long-run aggregate demand (LRAD) and long-run aggregate supply (LRAS) curves.
      • LRAD occurs when demand shocks are absent (εD=0) and inflation expectations are fixed (πe=π).
      • LRAS occurs when supply shocks are absent (εS=0) and inflation expectations are consistent with actual inflation (πe=π).
      • The long-run equilibrium implies that output is at its natural level (Y=Y*) and inflation is at the central bank's target (π=π*).

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    Description

    Explore the concepts of aggregate demand and its relationship with real interest rates in this quiz. Understand how inflation impacts output and the effects of monetary policy on consumption and investment decisions. Test your knowledge on these fundamental economic principles.

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