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Unformatted text preview: Click to edit Master subtitle style Dynamic Aggregate Demand and Aggregate Topics how to incorporate dynamics into the ADAS model we previously studied how to use the dynamic ADAS model to illustrate longrun economic growth how to use the dynamic ADAS model to trace out the effects over time of various shocks and policy changes on Introduction The dynamic model of aggregate demand and aggregate supply gives us more insight into how the economy works in the short run. It is a simplified version of a DSGE model, used in cuttingedge macroeconomic research. (DSGE = Dynamic, Stochastic, Introduction The dynamic model of aggregate demand and aggregate supply is built from familiar concepts, such as: the IS curve, which negatively relates the real interest rate and demand for goods & services the Phillips curve, which relates inflation to the gap between output and its natural level, expected inflation, and supply shocks How the dynamic ADAS model is different from the standard model Instead of fixing the money supply, the central bank follows a monetary policy rule that adjusts interest rates when output or inflation change. The vertical axis of the DADDAS diagram measures the inflation rate, not the price level. Subsequent time periods are linked together: Changes in inflation in one period alter expectations of future inflation, which Keeping track of time The subscript t denotes the time period, e.g . Yt = real GDP in period t Yt 1 = real GDP in period t 1 Yt +1 = real GDP in period t + 1 We can think of time periods as years. E.g ., if t = 2008, then Yt = Y 2008 = real GDP in 2008 The models elements The model has five equations and five endogenous variables: output, inflation, the real interest rate, the nominal interest rate, and expected inflation. The equations may use different notation, but they are conceptually similar to things Output: The Demand for Goods and Services ( ) t t t t Y Y r = + 0, output natural level of output real interest rate Negative relation between output and interest rate, same intuition as IS curve. Output: The Demand for Goods and Services ( ) t t t t Y Y r = + demand shock, random and zero on average measures the interestrate sensitivity of demand natural rate of interest in absence of demand shocks, t t Y Y = when t r = The Real Interest Rate: The Fisher Equation 1 t t t t r i E + = nominal interest rate expected inflation rate ex ante (i.e. expected) real interest rate increase in price level from period t to t +1, not known in period t expectation, formed in period t , of inflation from t to t +1 1 t + = 1 t t E + = Inflation: The Phillips Curve 1 ( ) t t t t t t E Y Y  = + + previously expected inflation current inflation supply shock, random and zero on average indicates how much inflation responds when output fluctuates around its natural level Expected Inflation:...
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 Spring '11
 Wilson

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