AD-IA Model and ZLB

Question 1

How does inflation behave? How can this give the MP Curve?

Answer 1

• When Y<Ybar, inflation is low
• Inflation is given at any given point, therefore does not respond to disturbances immediately
• Monetary Policy: C.B. chooses real IR dependant on π and Y (Taylor Rule)
• When π rises, r rises => r = r(π, Y)
• MP curve: r = α + βπ + γ (Y - Ybar)

Question 2

What is the Inflation Adjustment (IA) line?

Answer 2

• IA= Horizontal line π at a point is irrespective of Y
• Line shifts up/down dependant on where Y is compared to Y bar
• This meets the AD curve- which shows that π increases reduced Y (PC)
• If Y>Ybar, inflation increases until AD=IA=Ybar

Question 3

What is the IS-MP LR equilibrium?

Answer 3

• IS curve shows the real IR which makes market for loans in the equilibrium. Savings = investment
• LR real interest rate = real IR; if prices are flexible

Question 4

How does expansionary fiscal policy look in the AD-IA model?

Answer 4

• IS Curve shifts right, shifting the AD curve right
• IA curve shifts up, leading to higher inflation => causing the MP curve so shift out in the LR
• BUT/ this may cause crowding out

Question 5

How does contractionary monetary policy look in the AD-IA model?

Answer 5

• MP Curve shifts left due to a change in α, Y falls and AD shifts left
• This means that the IA curve shifts down, reducing inflation
• MP curve therefore shifts down due to a change in β- giving a net neutral effect

Question 6

What happens to the Taylor Rule in the LR?

Answer 6

• α=r*
• In the LR, π = (r - α) / β
• Higher values of r* gives lover values of π
• Higher β gives less π

Question 7

What are supply shocks? What can cause these shocks?

Answer 7

• Supply shocks are anything that can impact potential output
• Changes in INPUTS: NRU or Labour Force
• Changes in OUTPUTS: Productivity

Question 8

How do firms determine prices (Variables)?

Answer 8

• Wages: increased wages means higher costs and more inflation
• Other labour costs such as health insurance play a part
• Costs of other inputs: Raw materials, Energy Costs
• Productivity: Increased prifuctivity reduces the cost of production- reducing inflation

Question 9

What are inflation shocks? What can cause inflation shocks?

Answer 9

• Inflation shock are anything that affect the rate of inflation
• Inflation shocks can be favourable (Shift down of IA curve)
• Changes in Eπ can create inflation shocks
• Credible central banks can reduce inflation through expectations, without necessarily reducing output that much

Question 10

What is the Zero Lower Bound? How does this link to Eπ?

Answer 10

• ZLB = where the nominal IR is approximately zero
• If r = i - Eπ, then the you cannot impact the real rate
• If Eπ falls, r can actually rise- therefore hampering expansion
• Eπ depends on output and is persistent
• If the economy is at a ZLB, MP Curve will be kinked- as you cannot reduce r further

Question 11

If the IS curve intersects the flat MP curve past the equilibrium, what happens?

Answer 11

• As the MP curve is flat, we see a ‘>’ shape
• This states that as π falls, so does Y- creating a liquidity trap
• At high π, real IR is determined by policy rule (AD \ )
• At low π, ZLB prevents CB from policy rule (AD / )

Question 12

How can the US 2007/08 be an example of how the AD curve can break down?

Answer 12

• FIs held MBS and other assets
• House prices fell, weakening the balance sheet
• This created a credit market disruption; causing a credit crunch
• Consumer confidence and investor confidence fell, shifting the IS curve left
• Fed cut the nominal interest rate to 0; stayed until December 2015
• Falling IS means that we move to the flat MP curve
• AD shifted left but IA remained constant [avoided a deflationary spiral]

Question 13

What happened in the GFC within the AD-IA model?

Answer 13

• Central Bank cut FFR to around 0
• Y<Ybar for a long time without deflation
• Inflation was around 1-2% due to Eπ being well anchored

Question 14

How can an economy avoid the liquidity trap?

Answer 14

• When the IS curve shifts left, it is not permenant
• To escape it, IS must intercept MP at a positive place
• Policy options include fiscal, reduce other rates or anchor expectations [LTIR are still +ve]
• C.B. can shift target interest rate and reduce yields via QE
• Interest rates shift IS curve right
• QE shifts due to it being a different rate