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# ch14b - The normal state around which the economy...

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1 CHAPTER 14 Dynamic AD-AS Model The model’s long-run equilibrium § The normal state around which the economy fluctuates. § Two conditions required for long-run equilibrium: § There are no shocks: § Inflation is constant: 0 t t ε ν = = 1 t t π π - =

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2 CHAPTER 14 Dynamic AD-AS Model The model’s long-run equilibrium § Plugging the preceding conditions into the model’s five equations and using algebra yields these long-run values: t t Y Y = t r ρ = * t t π π = * 1 t t t E π π + = * t t i ρ π = +
3 CHAPTER 14 Dynamic AD-AS Model The Dynamic Aggregate Supply Curve § The DAS curve shows a relation between output and inflation that comes from the Phillips Curve and Adaptive Expectations: 1 ( ) - = + - + t t t t t Y Y π π φ ν ( DAS )

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4 CHAPTER 14 Dynamic AD-AS Model The Dynamic Aggregate Supply Curve DAS slopes upward: high levels of output are associated with high inflation. Y π DA S t 1 ( ) - = + - + t t t t t Y Y π π φ ν DAS shifts in response to changes in the natural level of output, previous inflation, and supply shocks.
5 CHAPTER 14 Dynamic AD-AS Model The Dynamic Aggregate Demand Curve § To derive the DAD curve, we will combine four equations and then eliminate all the endogenous variables other than output and inflation. Start with the demand for goods and services: ( ) t t t t Y Y r α ρ ε = - - + 1 ( ) + = - - - + t t t t t t Y Y i E α π ρ ε using the Fisher eq’n

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6 CHAPTER 14 Dynamic AD-AS Model The Dynamic Aggregate Demand Curve 1 ( ) + = - - - + t t t t t t Y Y i E α π ρ ε result from previous slide ( ) = - - - + t t t t t Y Y i α π ρ ε using the expectations eq’n * [ ( ) ( ) ] = - + + - + - - - + t t t t t Y t t t t Y Y Y Y π α π ρ θ π π θ π ρ ε using monetary policy rule * [ ( ) ( )] = - - + - + t t t t Y t t t Y Y Y Y π α θ π π θ ε
7 CHAPTER 14 Dynamic AD-AS Model The Dynamic Aggregate Demand Curve result from previous slide combine like terms, solve for Y * [ ( ) ( )] = - - + - + t t t t Y t t t Y Y Y Y π α θ π π θ ε 1 A 0, B 0 1 1 = = + + Y Y π αθ αθ αθ * A( ) B , = - - + t t t t t Y Y π π ε where ( DAD )

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8 CHAPTER 14 Dynamic AD-AS Model The Dynamic Aggregate Demand Curve DAD slopes downward: When inflation rises, the central bank raises the real interest rate, reducing the demand for goods & services. Y π DAD shifts in response to changes in the natural level of output, the inflation target, and demand shocks. DA D t * A( ) B = - - + t t t t t Y Y π π ε
9 CHAPTER 14 Dynamic AD-AS Model Y t The short-run equilibrium In each period, the intersection of DAD and DAS determines the short-run eq’m values of inflation and output. πt Yt Y π DA D t DA S t A In the eq’m shown here at A , output is below its natural level.

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10 CHAPTER 14 Dynamic AD-AS Model Long-run growth Period t : initial eq’m at A Y π DA S t Yt DAD t A Yt πt Period t + 1 : Long-run growth increases the natural rate of output. Yt + 1 DAS t +1 DAD t +1 B πt + 1 πt = DAS shifts because economy can produce more g&s DAD shifts because higher income raises demand for g&s New eq’m at B , income grows but inflation remains stable.
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ch14b - The normal state around which the economy...

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