24 Questions
What is the effect of a 1 pp increase in the real interest rate on output?
Reduces output by 1% of its natural level
What happens to the DAS and DAD curves as a result of long-run growth?
Both curves shift to the right
What is the value of ϕ, which represents the change in inflation when output is above its natural level?
0.25
What is the effect of a 1 pp change in the exogenous variable of interest on the economy?
A 1 pp change in the endogenous variables
What is the value of θπ, which is the weight on inflation in the monetary policy rule?
0.5
What happens to inflation when the economy moves from point A to B in the long-run growth scenario?
Inflation remains unchanged
What is the reason for the rightward shift of the DAS curve in the long-run growth scenario?
Increase in the natural level of output
What is the value of πt∗, which represents the target inflation rate?
2%
What is the effect of a higher natural level of output on people?
They want more goods and services.
What happens to the overall price level due to simultaneous movements in the economy?
It has no effect on prices.
What is the result of a long-run growth with stable inflation?
Higher output and stable inflation.
What happens to the DAS curve when νt rises to 1% for one period?
It shifts upward/left by 1 pp.
What is the effect of higher inflation on the economy?
It induces the Central Bank to raise interest rates.
What happens to the DAS curve after the initial shock, when expected inflation is higher?
It moves back to its initial position slowly.
What is the effect of the supply shock on output?
It decreases output below its natural level.
What is the final outcome for inflation after the transition period?
It returns to 2%.
In the long-run equilibrium, what is the relationship between the inflation rate and the natural level of interest rate?
it = ρ + πt∗
What is the effect of the Central Bank's inflation target on real variables in the long-run equilibrium?
It has no impact on real variables
What is the condition for Et πt+1 = πt∗ in the long-run equilibrium?
Et πt+1 = πt
What is the relationship between output and inflation in the dynamic AS curve?
Higher output levels lead to higher inflation
What happens to the dynamic AS curve when πt−1, Ȳt, or νt changes?
The curve shifts
What is the slope of the dynamic AS curve?
ϕ
What is the vertical intercept of the dynamic AS curve?
πt−1 + νt
What is the result of the classical dichotomy in the long-run equilibrium?
Money is neutral
Study Notes
Dynamic Model of AD and AS
- The model assumes a long-run equilibrium with a 1% change in exogenous variables, and the other exogenous variables are assumed constant.
- The model is used to analyze the effects of:
- Long-run growth
- Shock to AS
- Shock to AD
- Shift in monetary policy
Long-run Growth
- The natural level of output (Ȳt) grows over time due to population growth, capital accumulation, and technological progress.
- The growth rate of Ȳt is taken as exogenous.
- Both DAS and DAD curves move to the right by the same amount, resulting in no change in inflation.
- The economy can produce more goods and services, making people richer and increasing demand, but this does not put upward pressure on prices.
AS Shock
- A rise in νt (e.g., due to an increase in world oil prices or minimum wages) causes DAS to shift upward/left by 1 pp.
- There is no effect on DAD, so the economy moves along the DAD curve.
- Inflation rises, but the central bank responds by increasing interest rates, which dampens output and reduces inflation.
- After the initial shock, the economy slowly returns to its initial position, with output below its natural level and inflation above its target.
Dynamic AS Curve
- The dynamic AS curve is derived from the DAS equation: πt = πt−1 + ϕ(Yt − Ȳt) + νt.
- The curve shows a linear relationship between πt and Yt, with a vertical intercept of πt−1 + νt and a slope of ϕ.
- Higher levels of output lead to higher marginal costs and higher inflation.
Solving the Model
- The long-run solution shows that Yt = Ȳt, rt = ρ, πt = πt∗, and Et πt+1 = πt∗.
- The model exhibits classical dichotomy and money neutrality, meaning that the central bank's inflation target only affects inflation, expected inflation, and nominal interest rates, and does not influence real variables.
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