L7 AD curve

Question 1

What does the AD curve endogenise?

Answer 1

Inflation!

Question 2

What does a lower inflation rate imply and how does it link to Y?

Answer 2

It implies a higher R via the monetary policy rule. This raises Y.

This is illustrated in the IS-MP diagram with the MP curve shifting up and the equilibrium Y falling

Question 3

What determines to the slope of AD?

Answer 3

1. How much does R respond to Pi?
   - feedback parameter m_pi, a higher value means a larger change in r for small changes in pi so flatter AD
2. How much does Y respond to r?
   - flatter IS curve -> flatter AD
   Determined by slope of I(r) and the multiplier size

Question 4

Describe the chair of reasoning behind the ZLB. What happened if pi falls and it meets ZLB? (7)

What would happen if we had lower inflation expectations?

Answer 4

As pi falls, the MP curve shifts downwards. If it intersects the IS curve at a point r lower than the lower bound, then we find that aggregate income cannot rise above Ŷ.

If we had lower pi, then -pi would be larger (relative to if we had higher inflation expectations), so the floor on R would be higher. This means that aggregate income would be lower

Question 5

What does the AD curve look like with a ZLB? (8)

And what happens if inflation expectations rise?

Answer 5

It has a kink ;)

The ZLB falls, so easier to reach the equilibrium output in the event of a fall in inflation (which would shift MP down, this increasing Y)