Stabilisation Policy and AD-AS

Question 1

What does the SR model consist of? What does this mean?

Answer 1

• SR model includes IS curve, PC and MP curve
• There is a tradeoff between SR output and inflation; C.B. chooses Rt rate
• Bank rate is determined by the Taylor Rule

Question 2

What is the AD Curve? What affects the AD curve?

Answer 2

• Combining the Taylor Rule with the IS Curve gives;
  AD = a - bm (πt - πbar)
• The AD curve describes how Rt affects Yt
• Higher inflation increases Rt, whilst increased Rt reduces output
• Changes in π: MOVEMENT
• Changes in b or m: SLOPE
• Changes in a or πbar: SHIFT

Question 3

What is the AS Curve?

Answer 3

• Combining the Phillips Curve with the price setting equation gives;
  AS = πt = πt-1 + demand conditions + shocks
• This has adaptive expectations
• if the shocks are positive inflationary shocks, this will shift AS curves, meaning inflation expectation changes until in line with π

Question 4

What is the AD-AS Steady State in the SR?

Answer 4

• Shocks = 0, a = 0, Y^t = 0,
• Therefore π* = πbar

Question 5

What happens when there is an inflation shock?

Answer 5

• Assuming a one-time, permenant increase in π
• This results in a positive shock, AS curve shift upwards
• Higher π and lower SR output- causing stagflation
• In period 2, shocks are eliminated but expectations of inflations are higher
• This means that AS permenantly shifts upwards
• Inflation will eventually ease

Question 6

What happens when there is a disinflation shock?

Answer 6

-Suppose policymakers wasnt to reduce inflation target
- As πbar reduces, AD shifts down, reducing Y and π
- As a response, Rt will increase- having a contractionary stance
- AS curve in period 2 shifts down
- This will occur until until the new target is reached

Question 7

What happens when there is a AD shock?

Answer 7

• Suppose at t=0, abar> a=0, for 10 periods- tending towards 0
• AD curve shifts upwards as abar rises, increasing π and Y^
• AS curve slowly shifts upwards as Eπ
• This will continue until inflation is greater thab the Natural Rate
• In the final period, AD curve immediately jumps back- reducing inflation and Y^
• THEREFORE, AD shocks have no LR implications on the economy but can only increase SR volatility

Question 8

How can the Federal Funds Rate be predicted?

Answer 8

• Fisher Equation can now be written as: i = rbar + mbar (πt - πbar) + πt
• This policy rate is very closely mirroered to the actual rate

Question 9

What is the Paradox of Policy? How can this be solved?

Answer 9

• SR Model suggests that to achieve goals/return to a steady state, you must sometimes push an economy to a recession
• Solution: Delegate recessionary policymaking to people who are not elected, anchoring Eπ, which will increase certainty

Question 10

What happens when the C.B. reduces expected inflation? How can this be done?

Answer 10

• AS immediately shifts down in line with the immediate AD curve
• This reaches a lower inflation without causing a recession
• Can be done via committing to the target, anchoring inflation expectations or maintaining flexibility