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Unformatted text preview: DAS/DAD 00:08 14.1 Elements of the Model Output: There is a negative relationship between the real interest rate and the demand for output. When the real interest rate rises, borrowing becomes more expensive, and saving yield a greater reward – thus less investments. – Thus reducing demand for G&S The parameter (a) tells us how sensitive demand is to changes in the real interest rate. The larger a, the more the demand for Y responds negatively to a given change in the real interest rate. Eta ( e) , exogenous shifts in demand. It also represents fiscal policy changes that affect demand, such as an increase in G. Rho ( p) , is the natural rate of interest Inflation: Phillips Curve In this model, the state of the business cycle is measured by deviation of output from its natural level. Expected Inflation: Adaptive Expectations Inflation expectations are based on inflation they have recently observed. Nominal Interest Rate: The Monetary Policy Rule We assume that the central bank sets a target for the nominal interest rate based on inflation and output. As inflation rises above its target or output rises above its natural level, the real interest rate rises. And as inflation falls below its target or output falls below its natural level, the real interest rate falls. The central banks is assumed to set a target for the nominal interest rate. It then adjusts the money supply to whatever level is necessary to ensure that the equilibrium interest rate hits the target. LongRun Equilibrium: The LongRun equilibrium reflects two related principles: the classical dichotomy and monetary neutrality. Classical Dichotomy: separation of real from nominal variables Monetary Neutrality: the property according to which monetary policy does not influence real variables. Dynamic Aggregate Supply: The Phillips Curve plus the substitution of expected inflation becomes the DAS schedule This graphs the relationship between inflation and output. Other things equal, high levels of economic activity are associated with high inflation. Dynamic Aggregate Demand: There are 4 parts to the DAS schedule Demand of goods and services The Fisher Equation for the real interest rate Nominal interest Rate (Monetary Policy Rule) Inflation Expectations (adaptive) The conventional Aggregate Demand curve is drawn for a given money supply. By contrast, because the monetary policy rule was used to derived the DAD, the DAD curve is drawn for a given rule for monetary policy....
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This note was uploaded on 02/23/2012 for the course ECON 420 taught by Professor Hill during the Fall '08 term at UNC.
 Fall '08
 Hill

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