Lecture 6 - Stabilisation Policy Flashcards
(20 cards)
What does the short-run model consist of?
The short-run model consists of the IS curve, MP curve (monetary policy), and the Phillips curve, which describe the relationship between output, interest rates, and inflation.
What is stagflation?
Stagflation is a combination of stagnant economic growth (recession) and high inflation, often caused by supply shocks like an oil price increase.
What happens in the steady state of the AS/AD model?
In the steady state, short-run output (\tilde{Y}t = 0), inflation is constant ((\pi_t = \pi{t-1})), and there are no shocks ((\bar{a} = 0), (\bar{\sigma} = 0)). Inflation equals the target: (\pi^* = \bar{\pi}).
How does an inflation shock affect the economy?
An inflation shock (e.g., oil price increase) shifts the AS curve up, causing higher inflation and lower output (stagflation). Over time, inflation eases as the economy returns to steady state.
What is disinflation?
Disinflation is a reduction in the inflation rate. If the central bank lowers the inflation target, the AD curve shifts down, leading to lower inflation but potentially higher unemployment initially.
What is a positive AD shock?
A positive AD shock (e.g., increased demand) shifts the AD curve up, raising output and inflation. Firms may raise prices, shifting the AS curve up over time.
What is the time inconsistency problem?
The time inconsistency problem occurs when policymakers deviate from announced policies (e.g., fighting inflation) for short-term gains (e.g., reducing unemployment), leading to loss of credibility.
How do rational expectations affect inflation?
With rational expectations, firms and households adjust behavior based on credible central bank policies, making inflation easier to control without causing recessions.
What is inflation targeting?
Inflation targeting is a monetary policy strategy where the central bank commits to a specific inflation rate, anchoring expectations and providing flexibility to respond to shocks.
What is the advantage of an explicit inflation target?
An explicit inflation target helps anchor inflation expectations, making it easier for the central bank to stabilize the economy without causing volatility.
How does an oil price shock affect the AS curve?
An oil price shock shifts the AS curve up and to the left, causing higher inflation and lower output (stagflation).
What happens when the central bank raises the inflation target?
Raising the inflation target shifts the AD curve up, leading to higher inflation and output in the short run. In the long run, the economy adjusts to the new target.
What is the paradox of policy and rational expectations?
The paradox is that credible central banks can stabilize inflation without causing recessions, but politicians may lack incentives to pursue such policies due to short-term costs.
How does military spending affect the AD curve?
An increase in military spending raises aggregate demand, shifting the AD curve to the right.
What is the monetary policy (Taylor) rule?
The monetary policy rule is:
Rₜ − r̄ = m(πₜ − π̄)
Where:
• Rₜ = real interest rate
• r̄ = marginal product of capital
• m = policy aggressiveness to inflation
• πₜ = current inflation rate
• π̄ = inflation target
How is the AD curve derived?
The AD curve is derived by combining IS curve and monetary policy rule:
Ỹₜ = ā − b̄m(πₜ − π̄)
Where:
• Ỹₜ = output gap
• ā = demand shock parameter
• b̄ = interest rate sensitivity
• m = policy parameter
• πₜ = inflation
• π̄ = inflation target
What does the slope of the AD curve represent?
The AD curve slope is:
−1/(b̄m)
Shows how output responds to inflation changes.
Steeper when:
• b̄ (interest sensitivity) is smaller
• m (policy aggressiveness) is larger
What is the AS curve equation?
AS curve (Phillips Curve):
πₜ = πₜ₋₁ + vỸₜ + σ̄
Where:
• πₜ = current inflation
• πₜ₋₁ = previous period’s inflation
• v = slope parameter
• Ỹₜ = output gap
• σ̄ = inflation shock
What is stagflation?
Stagflation occurs when:
• AS curve shifts ↑ (due to positive σ̄ shock like oil prices)
• Results in:
High π (inflation)
Low Ỹ (output gap/recession)
• Graphically: Economy moves northwest on AD curve
