Keynesian AD-AS Model

What is a key feature of this model?

Price stickiness

What is the difference between AS-AD and RBC

It distinguishes between what happens in the short and long run

What is potential output?

When factors of production are used at their long run level

What is the output gap

Endogenous percentage deviation of current output from potential output/trend

What are the three behavioural equations?

Ct = (ac+ac,t)Y bar t

Gt = (ag+ag,t)Y bar t

It = (ai + ai,t - b(Rt-R)) Y bar t

Describe the behavioural equation for consumption

Ac is exogenous constant long run share of potential output going to consumption

Ac,t is short run shock on demand for consumption, = 0 in long run

Describe the behavioural equation for government purchases

Ag is exogenous constant long run share of potential output going to government purchases

Ac,t is short run fiscal shock = 0 in long run

Describe the behavioural equation for investment

Ai is the constant long run share of potential output going to investment

Ac,t is short run shock on demand for investment

In long run, ai,t = 0, Rt = R, It = ai Ybar t

What can be used to express IS curve?

An output gap

At - b (Rt-R)

What causes the IS to shift?

AD shocks

What is the MP curve?

Short run real interest rate implied by nominal interest rate

What is contractionary policy ?

Central bank sets a higher nominal ir

Sticky inflation leads to Rt increasing above R

Firms fin it more costly to invest so invest in financial market

Output reduces because of less investment

Eventually Rt goes back to R

How does CB choose Rt?

Inflation targeting

Rt-r = m(pi - pi bar) + epsilon

Why do the central banks follow this?

Prevents price distortions

Reduces menu costs

Helps with expectations

Helps with credibility

How do you get the aggregate demand curve?

Add IS + MP

How are normal rigidities introduced in Keynesian?

Because firms have market power

• some cant change their price every period

• Some face menu costs

How do firms set their price in Keynesian model ?

Inflation expectation

Demand conditions

Exogenous shocks on cost of production

How is inflation in the economy given?

Pi t = expected pi t + v Y tilda t + o t

This is the Phillips curve

What happens when we assume adaptive expectations?

The inflation curve pi = pi t-1

What are the two endogenous variables in equilibrium?

Y tilda t, pi t

What are the two equations?

AD

AS

What are the exogenous parameters

Pi bar, v, b, m

What are the exogenous shocks

At, epsilon t, ot

What does the model tell us should be the case if driven by demand shocks

Inflation should be pro cyclical

What does the model tell us should be the case if driven by supply shocks?

Inflation should be counter cyclical

What does AS-AD tell us about monetary policy?

Aims to keep inflation stable

Tradeoff between lower inflation and higher output

What does AS-AD tell us about fiscal policy?

Shocks to gov purchases shift AD

Less used for stabilisation because of lags

Most policy is automatic stabilisers

Countries with a lot of debt are constrained

More useful with zero lower bound

Summary of AS-AD

Nominal values jointly determined

Demand and supply shocks have different impacts on inflation

Because of normal rigidities, there is role for policy in stabilising the economy