Chapter 13 - AD/AS

Chapter 13: Aggregate Demand and Aggregate Supply
Ryan W. Herzog
Spring 2021
Ryan W. Herzog (GU) AD/AS Spring 2021 1 / 62

1 Introduction
2 Monetary Policy Rules and Aggregate Demand
3 The Aggregate Supply Curve
4 The AS/AD Framework
5 Macroeconomic Effects in the AD/AS Framework
6 Empirical Evidence
7 Modern Monetary Policy

Introduction
Learning Objectives
With systematic monetary policy, we can combine the IS curve and
the MP curve to get an aggregate demand (AD) curve.
That the Phillips curve can be reinterpreted as an aggregate supply
(AS) curve.
How the AD and AS curves represent an intuitive version of the
short-run model that describes the evolution of the economy in a
single graph.
The modern theories that underlie monetary policy.

Introduction
Question for this chapter: If we could formulate a systematic policy in
response to the various kinds of shocks that can possibly hit the economy,
what would the policy look like?

Monetary Policy Rules and Aggregate Demand
Short-run Model
The short-run model consists of three basic equations:
IS curve: Ỹ = a − b(Rt − r)
MP curve: Central Bank chooses Rt
Phillips curve: ∆πt = vỸt + o

The model implies that high short-run output leads to an increase in
inflation.
The central bank chooses how to make this trade-off by choosing the
interest rate.
A monetary policy rule is a set of instructions that determines the
stance of monetary policy for a given situation that might occur in
the economy.

Monetary Policy Rule
The rule we consider is that the stance of monetary policy depends on
current inflation and the inflation target
If inflation is above the target the real interest rate should be high
If inflation is below the target the real interest rate should be low

Simple Monetary Policy Rule
Rt − r = m(πt − π)
where:
Rt is the real interest rate
r is the long run interest rate
m governs how aggressively monetary policy responds to inflation
πt is current inflation
π is the inflation target

Aggregate Demand Curve
We can substitute the monetary policy rule into the IS curve.
The resulting equation is the aggregate demand (AD) curve.
IS curve: Ỹ = a − b(Rt − r)
MP rule: Rt − r = m(πt − π)
AD curve: Ỹt = a − bm(πt − π)

The Aggregate Demand Curve

AD Curve
The AD curve
Describes how the central bank chooses short-run output based on the
rate of inflation.
Is fundamentally different than market demand
If inflation is above target the central bank raises the interest rate to
lower output below potential.

The AD Curve
A change in inflation causes a movement along the AD curve
Changes in m will alter the slope of the AD curve
The slope of the AD curve is −1
bm
As the central bank becomes more aggressive targeting inflation:
m will increase
The slope of the AD curve will flatten

After an Inflation Shock

An Aggressive Monetary Policy Rule

Shifts of the AD Curve
Changes in the parameter a
Changes in the target rate of inflation π

The Aggregate Supply Curve
The aggregate supply (AS) curve is the price-setting equation used by
firms
Is the Phillips curve with a new name:
πt = πt−1 + vỸt + o (1)

The AS Curve
The point in the graph where short-run output equals zero is equal to
the inflation rate in the previous period.
The AS curve will shift due to:
The inflation rate changing over time
A change in the inflation shock parameter

The AS/AD Framework
AD and AS Curves
AD curve:
Ỹt = a − bm(πt − π) (2)
AS curve:
πt = πt−1 + vỸt + o (3)

The AS/AD Framework
The Steady State
In the steady state
the endogenous variables are constant over time
no shocks to the economy.
the inflation rate must be constant and short-run output is equal to
zero.
Steady state implies:
1 πt = πt−1 = π∗
2 Ỹ ∗
= 0

The AS/AD Framework
AD/AS Framework
The AS curve slopes upward which is an implication of price-setting
behavior of firms embodied in the Phillips curve
The AD curve slopes downward from the response of policymakers to
inflation.

The AS/AD Framework
AD/AS Framework

Macroeconomic Effects in the AD/AS Framework
Event 1: An Inflation Shock
The economy begins in steady state and is hit with a lasting increase
in the price of oil.
Thus, the parameter o
Is positive for one period
This inflation shock raises the price level permanently.
The AS curve will shift up as a result.
Stagflation which occurs with the stagnation of economic activity
accompanied by inflation.

Initial Response to an Inflation Shock

Time Effects in Period 2
o returns to normal.
The AS curve does not shift back because π1 > π
Inflation is now π2 = π1 + vỸ2 + 0

Chain of Events
High inflation created by the oil shock
↓
Raises expected inflation
↓
Slows the adjustment of the AS curve back to its initial position
↓
Inflation slowly falls.
↓
Eventually the model will return to its original steady state.

Two Periods after an Inflation Shock

Three Periods after an Inflation Shock

Summary
Movement back to the steady state is fastest when the economy is
furthest from its steady state.
In summary, the impact of a price shock
It raises inflation directly.
Even a single period shock raises expected inflation.
Inflation remains higher for a longer period of time.
It takes a prolonged slump to get expectations back to normal.
The economy suffers stagflation.

The Effects of an Inflation Shock: Summary

Event 2: Disinflation
Suppose the economy begins in steady state and policymakers decide
to lower the target rate of inflation.
The AD curve shifts down
The new rule calls for an increase in interest rates

The Initial Response to Disinflation

The economy must now move to its new steady state.
When actual output equals potential output, the new steady state is
at the new target rate of inflation.

The Dynamics of Disinflation

The change in the rate of inflation causes the AS curve to shift during
the following period.
Firms adjust their expectation for inflation to account for the new
lower inflation rate.
The AS curve shifts down.

The inflation rate is still above the target.
The central bank keeps actual output below potential.
The inflation rate falls further.
Eventually, the economy will rest in its new steady state.
Note that 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
Suppose there is a temporary increase in the aggregate demand
parameter a
The AD curve will shift out.
Prices increase.

A Positive AD Shock

As inflation has increased, firms expect higher inflation in the future.
Thus, the AS curve shifts upward over time.
The inflation rate associated with zero short-run output rises.
The AS curve shifts until the economy has higher inflation and zero
short-run output.

Dynamics as the AS Curve Shifts

The Unraveling after the AD Shock

The aggregate demand 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 staying at its original steady
state than going through this cycle.

A Positive AD Shock: Summary

Further Thoughts
In theory, monetary policy can be used to insulate an economy from
aggregate demand shocks.
The monetary policy rule we specified here responds only to inflation
and not output changes.

Empirical Evidence
Empirical Evidence
Question: What are the empirical predictions of the short-run model when
monetary policy is dictated by an inflation-based policy rule?

Empirical Evidence
Monetary Policy Rule
The Fisher Equation: Monetary policy rule in terms of the nominal
interest rate:
it = Rt + πt = r + πt + m(πt − π) (4)
The Taylor rule suggests picking parameter values that are functions
of 2.

Empirical Evidence
The Federal Funds Rate

Empirical Evidence
Inflation-Output Loops
When plotting inflation on the vertical axis and output on the
horizontal axis:
The economy will follow counterclockwise loops to shocks in the
economy.
Positive short-run output leads to rising inflation.
A rise in inflation leads policymakers to reduce output.

Empirical Evidence
Inflation Output Loops

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 across OECD Countries

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
Is there any benefit to creating a systematic policy?
The time consistency problem occurs even though an agent supports
a particular policy, once the future comes, they have incentives to
renege on their promises.
Firms and workers form expectations about inflation and build them
into pricing decisions.
Central bankers have incentives to pursue an expansionary policy.
Firms and workers anticipate the policy and build that anticipation
into - resulting in no benefit to output.
Policymakers need to commit to not exploit inflation expectations in
order to keep a low rate of inflation.

The Paradox of Policy and Rational Expectations
The goal of macroeconomic policy (full employment, output at
potential, and low, stable inflation)
The presence of a policymaker willing to generate a large recession to
fight inflation makes policy use less likely.

Adaptive Expectations
In the past we assumed πe
t = πt−1.
Also assume the equation doesn’t change with policy rule changes.
Our motivation for this assumption was the stickiness of inflation.

Rational Expectations
Rational expectations assumes 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 central banks 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
We can drop the assumption of adaptive expectations and rewrite the
AS curve in terms of the expected rate of inflation:
πt = πe
t + vỸt + o
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 then inflation
can be kept low without recessions.

Costless Disinflation by Coordinating Expectations

Inflation Targeting
In many countries, central banks have an explicit target rate of
inflation that they seek to apply over the medium horizon.
Explicit inflation targets which anchor inflation expectations and may
make it easier for central banks to stimulate output

Constrained discretion
A central bank has the flexibility to respond to shocks in the
short-run.
The bank is committed to particular rate of inflation in the long run.

Chapter 13 - AD/AS

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