Chapter 13:
Stabilization in the
AD/AS Framework
SPRING 2022 SEMESTER
13.2 Monetary Policy Rules and
Aggregate Demand
• The short-run model consists of the
• IS curve:
• MP curve: The central bank chooses
• Phillips:
• High short-run output increases inflation.
• The central bank faces this trade-off and chooses the interest
rate.
Simple Monetary Policy Rule
Real
interest Long-run Current Inflation
rate interest rate inflation target
Governs how aggressively
monetary policy responds
to inflation
The AD Curve—1
• Substitute the policy rule into the IS curve:
• Policy rule:
• IS curve:
• To get the aggregate demand (AD) curve:
• AD curve:
• Short-run output is a function of the inflation rate.
The AD Curve—2
AD
The AD Curve—3
• The AD curve
• is built from the demand side (IS curve).
• describes how the central bank sets short-run output for each
rate of inflation.
• Change in inflation
• A movement along the AD curve
• Changes in
• Alters the slope of the AD curve
The AD Curve after an Inflation Shock
B
π’
A
π
AD
~ ~
Y’ 0 Output,Y
An Aggressive Monetary Policy Rule
B
π'
A
π
AD
~ ~
Y' 0 Output,Y
Shifts of the AD Curve
• AD curve shifts are caused by:
• Changes in the parameter
• Changes in the target rate of inflation
13.3 The Aggregate Supply Curve
• The aggregate supply (AS) curve is
• the price-setting equation used by firms.
• the Phillips curve with a new name.
• AS curve equation:
The Aggregate Supply Curve—1
AS
πt–1
~
0 Output,Y
The Aggregate Supply Curve—2
• The AS curve will shift due to
• the inflation rate changing over time.
• change in the inflation shock parameter.
13.4 The AS/AD Framework
• Combining the AS and AD curve
• Two equations
• Two unknowns: inflation rate and short-run output
• AD curve
• AS curve
The Steady State—1
• In the steady state
• The endogenous variables are constant over time
• No shocks to the economy
• From the AS curve:
• Therefore,
The Steady State—2
• From the AD curve:
• So, in the steady state,
The AS/AD Framework
13.5 Macroeconomic Events: Event 1—
An Inflation Shock
• The economy begins in steady state.
• Suppose there is a lasting oil price increase.
• The parameter is positive for one period.
• The price level rises permanently.
• The AS curve will shift up as a result.
• Stagflation
• Combination of a recession and inflation
The Initial Response to an Inflation
Shock
AS1
AS
B
π1
A
π
AD
~ 0 ~
Y1 Output,Y
Event 1: An Inflation Shock—1
• In period 2,
• returns to normal.
• The AS curve does not shift back because
• Inflation is now:
• In the steady state,
• So,
Event 1: An Inflation Shock—2
High inflation from the oil
shock
Raises expected inflation
Slows the adjustment of
the AS curve back to its
initial position
Inflation slowly falls
The model returns to its
original steady state
Two Periods after an Inflation Shock
AS1 AS1
AS2 AS2
AS AS
B B
π1 π1 C
π2 A
π A π
AD AD
~ 0 ~ ~ ~ 0 ~
Y1 Output,Y Y1 Y2 Output,Y
Three Periods after an Inflation Shock
AS1
AS2
AS3
AS
B D
π1 C
π2
π3
π A
AD
~ ~~ 0 ~
Y1 Y2 Y3 Output,Y
Event 1: An Inflation Shock—3
• Transition dynamics:
• Movement back to the steady state is fastest when the
economy is furthest from its steady state.
• In summary, a price shock
• raises inflation directly.
• keeps inflation higher for a longer period of time due to sticky
inflation.
• results in a prolonged slump.
• causes the economy to suffer from stagflation.
The Effects of an Inflation Shock:
Summary
Event 2: Disinflation—1
• The economy begins in steady state.
• Suppose policymakers decide to lower the inflation
target.
• The AD curve shifts down.
• The new rule calls for an increase in interest rates.
The Initial Response to Disinflation
AS
A
π
B
π1
π
AD
AD1
The Dynamics of Disinflation
AS
AS1
A
π
B
π1
C
π
AD
AD1
~ ~
Y1 0 Output,Y
Event 2: Disinflation—2
Change in the rate of
inflation
Firms adjust expectations
of inflation (lower)
AS curve shifts to the right
Inflation is still above the
target; Output remains
below potential
Inflation rate falls further
Event 2: Disinflation—3
• Note:
• If the classical dichotomy holds in the short run, the AD and
AS curves would reach the new steady state immediately.
• If there is sticky inflation, a recession is needed to
adjust expectations down.
Event 3: A Positive AD Shock—1
• The economy begins in steady state.
• Suppose there is a temporary increase in the aggregate
demand parameter,
• The AD curve will shift out.
• Prices increase.
A Positive AD Shock
AS
B
π1
A
π
AD1
AD
0 ~ ~
Y1 Output,Y
Event 3: A Positive AD Shock—2
Increase and
inflation increases
Firms expect higher
future inflation
Increased demand for
goods
Firms increase prices
AS shifts upward
Dynamics as the AS Curve Shifts
AS8
C AS
π8
B
π1
A
π
AD1
AD
~ ~
0 Y1 Output,Y
The Unraveling after the AD Shock
Ends
AS8
C AS
π8
D B
π 1 =π 10
A
π
AD1
AD = AD10
~ 0 ~ ~
Y10 Y1 Output,Y
Event 3: A Positive AD Shock—3
• The AD shock implies that booms are matched by
recessions.
• The economy benefits from a boom but inflation rises.
• The way to reduce inflation is by a recession.
• The costs of inflation:
• The economy would have been better off at the original
steady state.
Further Thoughts on Aggregate
Demand Shocks
• In theory, monetary policy
• can be used to insulate an economy from AD shocks.
• responds only to inflation and not output changes.
• What are the empirical predictions of the short-run
model?
13.7 Modern Monetary Policy
• The short-run model captures many features of
monetary policy.
• Central banks are now more explicit about policies and
targets.
• Inflation rates in industrialized countries have been
well-behaved for the last 25 years.
Inflation in the OECD
More Sophisticated Monetary Policy
Rules
• Richer monetary policy rules that use short-run output
create results similar to the simpler model.
• The simple policy rule we used implicitly weights short-
run output.
Rules versus Discretion
• The time consistency problem
• Even though agents support a particular policy, once the
future comes, they have incentives to renege on their
promises.
• Firms and workers form expectations about inflation.
• Expectations are built into prices and contracts.
• Central bankers pursue an expansionary policy.
• Firms and workers anticipate the policy and build it in.
• No benefit to output
The Paradox of Policy and Rational
Expectations—1
• The goal of macroeconomic policy
• Full employment
• Output at potential
• Low, stable inflation
• The presence of a policymaker willing to generate a
large recession to fight inflation makes policy use less
likely.
The Paradox of Policy and Rational
Expectations—2
• Under adaptive expectations, we assume
• We assume the equation does not change with policy
rule changes.
• Due to sticky inflation
The Paradox of Policy and Rational
Expectations—3
• Rational expectations
• People use all information at their disposal to make their best
forecast of the rate of inflation.
• This information may include the costs resulting in
sticky inflation but may also add the target rate of
inflation.
The Paradox of Policy and Rational
Expectations—4
• The central bank’s willingness to fight inflation is a key
determinant of expected inflation.
• If firms know the bank will fight aggressively to keep
inflation low,
• they are less likely to raise prices after an inflation shock.
Managing Expectations in the AS/AD
Model—1
• We can drop the assumption of adaptive expectations
and rewrite the AS curve in terms of the expected rate
of inflation: Expected
rate of
inflation
Managing Expectations in the AS/AD
Model—2
• If the Federal Reserve lowers the inflation target, the AD
curve shifts down.
• If expectations adjust immediately and people use all
information, the AS curve shifts down immediately to the new
target.
• If the central bank can control expectations of inflation,
it can be kept low without recessions
Costless Disinflation by Coordinating
Expectations
Case Study: Rational Expectations and
the Lucas Critique
• The Lucas critique
• It is inappropriate to build a macroeconomic model based on
equations in which expectations are not consistent with the
statistical properties of the economy.
• Models should incorporate the theory of rational
expectations.
Inflation Targeting
• Managing expectations
• Explicit inflation targets
• Anchor inflation expectations
• Easier to stimulate output
• Constrained discretion
• Maintaining flexibility to respond to shocks
• Commitment to particular inflation rate in the long run
13.8 Conclusion
• A credible, transparent commitment to a low rate of
inflation is one of the key factors in taming inflation.
• Anchors inflation expectations so that shocks are deflected
quickly
• Stabilizes economy
• The period after the 1980–1982 recession
• “The Great Moderation”
• Relative stability of the macroeconomy