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Unformatted text preview: In this chapter, you will learn: 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 output, inflation, and other endogenous variables Chapter 14: A Dynamic Model of Aggregate Demand and Aggregate Supply 2 CHAPTER 14 Dynamic ADAS Model 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, General Equilibrium) 3 CHAPTER 14 Dynamic ADAS Model 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 adaptive expectations, a simple model of inflation expectations 4 CHAPTER 14 Dynamic ADAS Model 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 changes aggregate supply in future periods, which further alters inflation and inflation expectations. 5 CHAPTER 14 Dynamic ADAS Model Keeping track of time The subscript “ t ” denotes the time period, e.g . Y t = real GDP in period t Y t 1 = real GDP in period t – 1 Y t +1 = real GDP in period t + 1 We can think of time periods as years. E.g ., if t = 2008, then Y t = Y 2008 = real GDP in 2008 Y t 1 = Y 2007 = real GDP in 2007 Y t +1 = Y 2009 = real GDP in 2009 6 CHAPTER 14 Dynamic ADAS Model The model’s 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 you’ve already learned. The first equation is for output… 7 CHAPTER 14 Dynamic ADAS Model Output: The Demand for Goods and Services ( ) t t t t Y Y r α ρ ε = + 0, α ρ output natural level of output real interest rate Negative relation between output and interest rate, same intuition as IS curve. 8 CHAPTER 14 Dynamic ADAS Model Output: The Demand for Goods and Services ( ) t t t t Y Y r α ρ ε = + demand shock, random and zero on average measures the interestrate...
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This note was uploaded on 06/12/2011 for the course ECON 101 taught by Professor Dee during the Spring '10 term at Andhra University.
 Spring '10
 dee
 International Economics

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