Podcast
Questions and Answers
How does a higher real interest rate affect consumption according to the consumption function?
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?
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?
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?
What is represented by the term A in the output equation?
In the context of the extended Keynesian model, what happens when real interest rate r is raised?
In the context of the extended Keynesian model, what happens when real interest rate r is raised?
Which of the following factors could contribute to a shock to aggregate demand?
Which of the following factors could contribute to a shock to aggregate demand?
How is the natural output Y* related to the natural real rate r*?
How is the natural output Y* related to the natural real rate r*?
What does the equation Y - Y* = -γ(r - r*) + εD represent?
What does the equation Y - Y* = -γ(r - r*) + εD represent?
What does the AS curve primarily reflect in the short run?
What does the AS curve primarily reflect in the short run?
According to the natural rate hypothesis, in the long run, the economy gravitates towards which of the following?
According to the natural rate hypothesis, in the long run, the economy gravitates towards which of the following?
What is the primary factor that differentiates the short run AS curve from the long run AS curve?
What is the primary factor that differentiates the short run AS curve from the long run AS curve?
In the context of Okun's Law, what does a decrease in the unemployment rate typically indicate?
In the context of Okun's Law, what does a decrease in the unemployment rate typically indicate?
Which of the following formulas represents the Aggregate Demand relation as per the content?
Which of the following formulas represents the Aggregate Demand relation as per the content?
What is the relationship between inflation ($\pi$) and real output (Y) according to the AD curve?
What is the relationship between inflation ($\pi$) and real output (Y) according to the AD curve?
Which factor primarily determines the position of the AD curve?
Which factor primarily determines the position of the AD curve?
How does an increase in inflation ($\pi$) affect real interest rates ($r$) according to the monetary policy reaction function?
How does an increase in inflation ($\pi$) affect real interest rates ($r$) according to the monetary policy reaction function?
What role do inflation expectations play in the AS curve?
What role do inflation expectations play in the AS curve?
According to Okun's Law, a relationship exists between which two economic indicators?
According to Okun's Law, a relationship exists between which two economic indicators?
What does an upward sloping relationship in the AS curve indicate?
What does an upward sloping relationship in the AS curve indicate?
In the short-run equilibrium output formula, what components determine output (Y)?
In the short-run equilibrium output formula, what components determine output (Y)?
What effect does an increase in real interest rates ($r$) typically have on aggregate output (Y)?
What effect does an increase in real interest rates ($r$) typically have on aggregate output (Y)?
What happens to the policy interest rate when inflation increases above the central bank's target?
What happens to the policy interest rate when inflation increases above the central bank's target?
How is the real interest rate related to the nominal interest rate and inflation?
How is the real interest rate related to the nominal interest rate and inflation?
What does a downward sloping AD curve indicate regarding the relationship between inflation and output?
What does a downward sloping AD curve indicate regarding the relationship between inflation and output?
According to the Phillips Curve, what happens when unemployment decreases?
According to the Phillips Curve, what happens when unemployment decreases?
In the long run, what is the relationship between inflation and unemployment according to the Natural Rate Hypothesis?
In the long run, what is the relationship between inflation and unemployment according to the Natural Rate Hypothesis?
What does the AS curve represent in terms of the relationship between inflation and output?
What does the AS curve represent in terms of the relationship between inflation and output?
In the context of Okun's Law, what happens to cyclical unemployment when there is an output increase?
In the context of Okun's Law, what happens to cyclical unemployment when there is an output increase?
What variable in the AD curve represents the sensitivity of the central bank's policy rate to the inflation gap?
What variable in the AD curve represents the sensitivity of the central bank's policy rate to the inflation gap?
What characterizes the Long Run Aggregate Supply (LRAS) curve?
What characterizes the Long Run Aggregate Supply (LRAS) curve?
In a short run equilibrium, what is treated as exogenous?
In a short run equilibrium, what is treated as exogenous?
What happens to inflation expectations in the long run if the economy is at the natural rate of unemployment?
What happens to inflation expectations in the long run if the economy is at the natural rate of unemployment?
What will occur to output when both demand and supply shocks equal zero?
What will occur to output when both demand and supply shocks equal zero?
Which condition is necessary for the short-run AS curve to shift?
Which condition is necessary for the short-run AS curve to shift?
What effect does a negative demand shock have on the AD curve?
What effect does a negative demand shock have on the AD curve?
Higher real interest rates tend to increase consumption due to reduced cost of borrowing.
Higher real interest rates tend to increase consumption due to reduced cost of borrowing.
The parameter γC indicates the interest-sensitivity of consumption.
The parameter γC indicates the interest-sensitivity of consumption.
Investment demand decreases with a rise in the real interest rate because fewer projects become profitable.
Investment demand decreases with a rise in the real interest rate because fewer projects become profitable.
The equation Y = A - γr suggests that output Y is positively related to the real interest rate r.
The equation Y = A - γr suggests that output Y is positively related to the real interest rate r.
The natural output Y* can be expressed in terms of the natural real rate r*.
The natural output Y* can be expressed in terms of the natural real rate r*.
When aggregate demand shocks occur, they shift the components of A away from long run levels A*.
When aggregate demand shocks occur, they shift the components of A away from long run levels A*.
The extended Keynesian model shows that Y is independent of consumption and investment.
The extended Keynesian model shows that Y is independent of consumption and investment.
A decrease in the parameter γI would lead to an increase in the interest sensitivity of investment demand.
A decrease in the parameter γI would lead to an increase in the interest sensitivity of investment demand.
The AD curve has a downward sloping relationship between inflation π and output Y.
The AD curve has a downward sloping relationship between inflation π and output Y.
The AS curve has a downward sloping relationship between inflation π and output Y.
The AS curve has a downward sloping relationship between inflation π and output Y.
According to the extended Keynesian model, real interest rates have no effect on output Y.
According to the extended Keynesian model, real interest rates have no effect on output Y.
Inflation expectations play a critical role in determining the position of the AS curve.
Inflation expectations play a critical role in determining the position of the AS curve.
In the AD-AS model, the intersection of the AD and AS curves determines the equilibrium levels of output and inflation.
In the AD-AS model, the intersection of the AD and AS curves determines the equilibrium levels of output and inflation.
The relationship between output Y and real interest rates r is negative in the AD framework.
The relationship between output Y and real interest rates r is negative in the AD framework.
Okun's Law states that there is no relationship between unemployment and output.
Okun's Law states that there is no relationship between unemployment and output.
Supply shocks have no impact on the AS curve's position.
Supply shocks have no impact on the AS curve's position.
The short-run aggregate supply (AS) curve is influenced by inflation expectations.
The short-run aggregate supply (AS) curve is influenced by inflation expectations.
Okun’s Law suggests that a decrease in the unemployment rate is associated with an increase in output.
Okun’s Law suggests that a decrease in the unemployment rate is associated with an increase in output.
In the AD-AS model, permanent shocks always lead to a shift in the aggregate supply curve.
In the AD-AS model, permanent shocks always lead to a shift in the aggregate supply curve.
The equation $Y - Y^* = - heta( rac{r - r^*}{
ho}) +
u_D$ represents aggregate demand.
The equation $Y - Y^* = - heta( rac{r - r^*}{ ho}) + u_D$ represents aggregate demand.
The natural rate hypothesis implies that, in the long run, output is determined solely by the natural rate of unemployment.
The natural rate hypothesis implies that, in the long run, output is determined solely by the natural rate of unemployment.
The policy interest rate is increased when inflation is below the central bank's target.
The policy interest rate is increased when inflation is below the central bank's target.
When inflation is at its target level, the real interest rate equals the natural real rate.
When inflation is at its target level, the real interest rate equals the natural real rate.
The AD curve has a downward sloping relationship between the quantity of output and inflation.
The AD curve has a downward sloping relationship between the quantity of output and inflation.
The Phillips Curve indicates a direct relationship between unemployment and inflation.
The Phillips Curve indicates a direct relationship between unemployment and inflation.
According to Okun's Law, an increase in output leads to a decrease in unemployment.
According to Okun's Law, an increase in output leads to a decrease in unemployment.
The Long Run Aggregate Supply (LRAS) curve is typically represented as upward sloping.
The Long Run Aggregate Supply (LRAS) curve is typically represented as upward sloping.
The slope of the AD curve is determined by the sensitivity of the central bank’s policy rate to the inflation gap.
The slope of the AD curve is determined by the sensitivity of the central bank’s policy rate to the inflation gap.
Inflation expectations are fixed in the long run according to the Natural Rate Hypothesis.
Inflation expectations are fixed in the long run according to the Natural Rate Hypothesis.
In the case of supply shocks, the AS curve shifts leftward, indicating an increase in output.
In the case of supply shocks, the AS curve shifts leftward, indicating an increase in output.
In the short run, an increase in nominal interest rates results in a decrease in the real interest rate.
In the short run, an increase in nominal interest rates results in a decrease in the real interest rate.
The equation $Y - Y^* = -eta(u - u^*)$ defines the AD curve.
The equation $Y - Y^* = -eta(u - u^*)$ defines the AD curve.
When demand and supply shocks equal zero, the economy is considered to be in long run equilibrium.
When demand and supply shocks equal zero, the economy is considered to be in long run equilibrium.
A tighter labor market decreases wages and therefore decreases prices.
A tighter labor market decreases wages and therefore decreases prices.
In the SRAS curve, the output (Y) can be treated as exogenous.
In the SRAS curve, the output (Y) can be treated as exogenous.
How does the AD curve illustrate the relationship between inflation and output?
How does the AD curve illustrate the relationship between inflation and output?
What are the two main components that determine the position of the AD curve?
What are the two main components that determine the position of the AD curve?
Explain how inflation expectations affect the AS curve.
Explain how inflation expectations affect the AS curve.
What is the significance of Okun's Law in relation to output and unemployment?
What is the significance of Okun's Law in relation to output and unemployment?
What role do demand shocks play in shifting the AD curve?
What role do demand shocks play in shifting the AD curve?
Describe how the AS curve differs from the AD curve in terms of their slopes.
Describe how the AS curve differs from the AD curve in terms of their slopes.
What happens to equilibrium levels of output and inflation at the intersection of the AD and AS curves?
What happens to equilibrium levels of output and inflation at the intersection of the AD and AS curves?
In the context of the extended Keynesian model, what is the importance of real interest rates?
In the context of the extended Keynesian model, what is the importance of real interest rates?
How does the parameter γC influence consumption when real interest rates rise?
How does the parameter γC influence consumption when real interest rates rise?
What is the relationship between output Y and real interest rate r in the model?
What is the relationship between output Y and real interest rate r in the model?
In the context of the extended Keynesian model, what does the variable A represent?
In the context of the extended Keynesian model, what does the variable A represent?
How does a change in the real interest rate r affect investment I according to the investment function?
How does a change in the real interest rate r affect investment I according to the investment function?
What role do aggregate demand shocks εD play in the relationship between actual output Y and natural output Y*?
What role do aggregate demand shocks εD play in the relationship between actual output Y and natural output Y*?
What does the equation Y - Y* = -γ(r - r*) + εD signify in the economic model?
What does the equation Y - Y* = -γ(r - r*) + εD signify in the economic model?
How does an increase in γI affect the sensitivity of investment to changes in real interest rates?
How does an increase in γI affect the sensitivity of investment to changes in real interest rates?
Explain how the formula for natural output Y* relates to the natural real rate r*.
Explain how the formula for natural output Y* relates to the natural real rate r*.
What role do inflation expectations play in the short-run Aggregate Supply (AS) curve?
What role do inflation expectations play in the short-run Aggregate Supply (AS) curve?
How does Okun's Law articulate the relationship between unemployment and output in the short run?
How does Okun's Law articulate the relationship between unemployment and output in the short run?
What differentiates the short-run Aggregate Supply curve from the long-run Aggregate Supply curve?
What differentiates the short-run Aggregate Supply curve from the long-run Aggregate Supply curve?
What is the significance of the natural rate hypothesis in understanding the AS curve over a long period?
What is the significance of the natural rate hypothesis in understanding the AS curve over a long period?
How do shocks to aggregate demand or supply affect the equilibrium in the AD-AS model?
How do shocks to aggregate demand or supply affect the equilibrium in the AD-AS model?
What happens to the real interest rate when inflation rises and is above the central bank's target?
What happens to the real interest rate when inflation rises and is above the central bank's target?
Explain the relationship between inflation and unemployment as described by the Phillips Curve.
Explain the relationship between inflation and unemployment as described by the Phillips Curve.
How does the slope of the AD curve relate to the parameters α and γ?
How does the slope of the AD curve relate to the parameters α and γ?
According to Okun's Law, what happens to unemployment when there is an increase in output?
According to Okun's Law, what happens to unemployment when there is an increase in output?
What does the Long Run Aggregate Supply (LRAS) curve indicate about the economy's output?
What does the Long Run Aggregate Supply (LRAS) curve indicate about the economy's output?
What role do supply shocks play in the Aggregate Supply (AS) curve?
What role do supply shocks play in the Aggregate Supply (AS) curve?
Describe the significance of the natural rate hypothesis in the context of the Phillips Curve.
Describe the significance of the natural rate hypothesis in the context of the Phillips Curve.
How does a negative demand shock affect the AD curve?
How does a negative demand shock affect the AD curve?
In the context of aggregate demand, what does εD represent?
In the context of aggregate demand, what does εD represent?
What can lead to a shift in expectation regarding inflation in the AS curve?
What can lead to a shift in expectation regarding inflation in the AS curve?
How does the inverse relationship in Okun's Law connect unemployment and the output gap?
How does the inverse relationship in Okun's Law connect unemployment and the output gap?
What is the mathematical representation of the Phillips Curve?
What is the mathematical representation of the Phillips Curve?
What condition is necessary for the short-run AD curve to align with the long-run equilibrium?
What condition is necessary for the short-run AD curve to align with the long-run equilibrium?
What happens to inflation expectations when the economy stabilizes at the natural rate of unemployment?
What happens to inflation expectations when the economy stabilizes at the natural rate of unemployment?
How do inflation expectations influence the short-run aggregate supply (SRAS) curve?
How do inflation expectations influence the short-run aggregate supply (SRAS) curve?
The AS curve differs in the short run and the long run primarily due to the role of ______ expectations.
The AS curve differs in the short run and the long run primarily due to the role of ______ expectations.
According to Okun's Law, a decrease in the ______ rate typically suggests an increase in output.
According to Okun's Law, a decrease in the ______ rate typically suggests an increase in output.
The equation Y - Y* = -αγ(π - π*) + ______ represents the Aggregate Demand.
The equation Y - Y* = -αγ(π - π*) + ______ represents the Aggregate Demand.
In a short-run equilibrium, the output is treated as ______.
In a short-run equilibrium, the output is treated as ______.
The sensitivity of policy rate to the ______ gap is represented by α in the monetary policy rule.
The sensitivity of policy rate to the ______ gap is represented by α in the monetary policy rule.
Higher real interest rates lead to a decrease in investment demand due to higher cost of ______.
Higher real interest rates lead to a decrease in investment demand due to higher cost of ______.
In the equation Y = A - γr, the term A represents exogenous aggregate ______ components.
In the equation Y = A - γr, the term A represents exogenous aggregate ______ components.
The parameter γC indicates the interest-sensitivity of ______.
The parameter γC indicates the interest-sensitivity of ______.
Output Y is ______ in real interest rate r according to the extended Keynesian model.
Output Y is ______ in real interest rate r according to the extended Keynesian model.
The equation Y - Y* = -γ(r - r*) + εD represents the relationship between output and the natural ______ rate.
The equation Y - Y* = -γ(r - r*) + εD represents the relationship between output and the natural ______ rate.
A higher interest rate increases the opportunity cost of ______, discouraging investment.
A higher interest rate increases the opportunity cost of ______, discouraging investment.
The parameter γI measures interest-sensitivity of ______.
The parameter γI measures interest-sensitivity of ______.
Shocks to aggregate demand can represent anything that shifts components of A away from long-run ______ levels.
Shocks to aggregate demand can represent anything that shifts components of A away from long-run ______ levels.
Central banks increase interest rates in response to ______.
Central banks increase interest rates in response to ______.
In the equation for the monetary policy reaction function, 'i' stands for the policy interest rate and 'r*' represents the natural ______ rate.
In the equation for the monetary policy reaction function, 'i' stands for the policy interest rate and 'r*' represents the natural ______ rate.
The AD curve demonstrates a downward sloping relationship between ______ and output Y.
The AD curve demonstrates a downward sloping relationship between ______ and output Y.
According to the Phillips Curve, as unemployment ______, inflation increases.
According to the Phillips Curve, as unemployment ______, inflation increases.
The AS curve shows an upward sloping relationship between ______ and output Y, holding inflation expectations fixed.
The AS curve shows an upward sloping relationship between ______ and output Y, holding inflation expectations fixed.
The AD-AS model analyzes the interaction between aggregate demand and aggregate ______.
The AD-AS model analyzes the interaction between aggregate demand and aggregate ______.
In the long run, the Phillips Curve is vertical at the natural rate of ______.
In the long run, the Phillips Curve is vertical at the natural rate of ______.
The AD curve has a downward sloping relationship between inflation (Ï€) and real ______.
The AD curve has a downward sloping relationship between inflation (Ï€) and real ______.
Okun's Law expresses a relationship between the output gap and cyclical ______.
Okun's Law expresses a relationship between the output gap and cyclical ______.
In the AS curve, the position is determined by inflation expectations and supply ______.
In the AS curve, the position is determined by inflation expectations and supply ______.
The Phillips Curve demonstrates an inverse relationship between inflation and ______.
The Phillips Curve demonstrates an inverse relationship between inflation and ______.
The short-run aggregate supply (SRAS) curve is positively sloped due to the upward relationship between ______ and output.
The short-run aggregate supply (SRAS) curve is positively sloped due to the upward relationship between ______ and output.
When output Y is equal to the natural level Y*, unemployment is said to be at its ______ rate.
When output Y is equal to the natural level Y*, unemployment is said to be at its ______ rate.
Aggregate Demand can be expressed as Y = C + I + ______.
Aggregate Demand can be expressed as Y = C + I + ______.
In long-run equilibrium, both demand and supply shocks are equal to ______.
In long-run equilibrium, both demand and supply shocks are equal to ______.
The AD-AS model demonstrates that the intersection of the AD and AS curves determines equilibrium levels of inflation and ______.
The AD-AS model demonstrates that the intersection of the AD and AS curves determines equilibrium levels of inflation and ______.
Inflation expectations are treated as ______ in the short-run equilibrium framework.
Inflation expectations are treated as ______ in the short-run equilibrium framework.
According to the extended Keynesian model, when real interest rates rise, it typically leads to a ______ in aggregate output.
According to the extended Keynesian model, when real interest rates rise, it typically leads to a ______ in aggregate output.
Okun’s Law describes the relationship between unemployment and ______.
Okun’s Law describes the relationship between unemployment and ______.
The relationship between output Y and real interest rates can be characterized as ______ in the AD framework.
The relationship between output Y and real interest rates can be characterized as ______ in the AD framework.
The term ‘εD’ in the AD curve equation captures the effects of ______ on aggregate demand.
The term ‘εD’ in the AD curve equation captures the effects of ______ on aggregate demand.
The natural rate hypothesis claims that in the long run, the economy gravitates towards the natural rate of ______.
The natural rate hypothesis claims that in the long run, the economy gravitates towards the natural rate of ______.
Study Notes
Aggregate Demand (AD)
- The AD curve shows the negative relationship between inflation (Ï€) 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 (Ï€).
- The monetary policy reaction function shows the positive relationship between the real interest rate (r) and inflation (Ï€) based on:
- Natural real rate (r*)
- Central bank inflation target (Ï€*)
- 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 (Ï€) 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 (Ï€*).
- 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 (Ï€) 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
- Ï•: 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 (Ï€) 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 (Ï€) 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 (Ï€) 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 (Ï€) 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 (Ï€) 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 (Ï€): 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 (Ï€=Ï€*).
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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.
