Notes for Macroeconomic Policy in the AD/AS Model

Exam Results

  • Mean: 73.1%
  • Median: 74%
  • Highest Score(s): 96.5%

Recap of Chapter 13, Part 1

  • Two primary objectives of monetary policy:
    • Stabilize inflation
    • Stabilize economic activity
  • In many circumstances, both objectives point to the same policy action, termed the "divine coincidence."
  • Exception: Temporary supply shocks create a trade-off between the two objectives.

The Paradox of Thrift

  • Consider an economy in a long-run equilibrium (point 1).
  • If households reduce consumption to save more, the following occurs:
    • (A) Show effects in the 5 graphs of the AS/AD model, marking the new short-run equilibrium as point 2.
    • (B) If the central bank aims to stabilize output, potential actions include: no change, tighten, or ease.
    • Mark the new long-run equilibrium as point 3 in the AS/AD graphs.

Effects of Increased Desire to Save

  • Graphical representation:
    • From an original equilibrium, reduced consumption (C) leads to a demand drop for goods and services, resulting in a decrease in total income (Y).

Summary of The Paradox

  • Households saving more may seem beneficial, but as total income falls, households become poorer overall.
  • This shift is illustrated by the initial movement in the IS curve.
  • When consumption decreases (C), the demand for goods/services declines, leading to a drop in equilibrium total income Y.

Modern Reaction to The Paradox

  • Once monetary policy engages (e.g., eases), the paradox dissipates.
  • Lower interest rates (r3) stimulate demand, restoring current consumption back to potential output (YP).
  • Balanced consumption/saving decisions are critical for economic stability.
  • Higher saving can promote long-term growth as per Solow and Romer models.

Dynamics of Stabilization Policy

  • Stabilization Policy Desire:
    • Responses to negative demand shocks can return output to YP, with or without intervention.
    • Reasons for intervention include:
    1. Keeping inflation near target.
    2. Potentially speeding up recovery.

Speed of the Self-Correcting Mechanism

  • The effectiveness of self-correction depends on:
    1. Sensitivity of inflation relative to labor market conditions ("stickiness of prices").
    2. Inflation expectation formation methods (adaptive vs. rational).

Stickiness of Prices

  • Phillips Curve:
    extπ=extπ<em>e−extω(U−U</em>n)+ρext{π} = ext{π}<em>e - ext{ω}(U - U</em>n) + ρ
  • Differentiate two cases:
    • Small ω (sticky prices): slow response to shocks.
    • Large ω (flexible prices): fast response.

Short-Run Aggregate Supply Curve

  • The slope of the Phillips curve informs the slope of the short-run aggregate supply (SRAS) curve.
    • Flat Phillips curve indicates a flat SRAS curve.

Effects of a Negative Demand Shock

  • Increase in AD leads to
    • Large decreases in output
    • Small decreases in inflation.
  • Initial responses to demand shocks vary by the speed of self-correction.

Expectations Formation

  • At equilibrium, if expected inflation adjusts adaptively, responses can be slow, risking underestimation.
  • Rational Expectations (John Muth, Robert Lucas):
    • Agents know model dynamics and correctly use all available information for forecasting, leading to immediate adjustments.

Role of Price Stickiness

  • Sticky prices indicate that inflation responds slowly to shocks, leading to gradual movement toward long-run equilibrium.
  • Case for Active Monetary Policy: Strong in sticky environments; weak if prices are flexible.

Stabilization Policy Limitations

  • Three main lags affect the effectiveness of stabilization policies:
    1. Data Lag: Time taken for downturn indicators to surface.
    2. Recognition Lag: Time for policymakers to recognize a downturn.
    3. Effectiveness Lag: Time for policy changes to yield results.

Desirability of Stabilization Policy

  • Influenced by:
    1. Speed of Correcting Mechanism: Quick recovery diminishes need for active intervention.
    2. Length of Policy Lags: Prolonged lags reduce effectiveness of active policy.

The Taylor Rule

  • Describes monetary policy adjustments:
    r=extr∗+extλ(π−π<em>T)+ϕ(Y−Y</em>P)r = ext{r}^* + ext{λ}(π - π<em>T) + ϕ(Y - Y</em>P)
  • Taylor Principle: λ > 0; focuses on inflation gap and output gap.

Fiscal Policy & AD Shifting

  • Fiscal measures, such as tax cuts or increased government spending, can similarly shift the AD curve.
    • However, these come with additional legislative and implementation lags.

Causes of Inflation

  • Milton Friedman Quote: "Inflation is always and everywhere a monetary phenomenon."
  • In the AS/AD model, many factors influence inflation in the short run. In the long run, inflation hinges entirely on monetary policy.

Long-term Inflation Dynamics

  • The MP curve governs long-term inflation levels, largely independent of output dynamics.

Inflationary Policy Causes

  • Inflation often escalates due to attempts to boost output or employment, potentially impacted by political pressures.
  • Cost-Push Inflation: Rising costs lead to decreasing outputs and further increased inflation.
  • Demand-Pull Inflation: Tolerance for higher AD can lead to increased inflation due to rising wages and costs.

Historical Context & Mandates

  • The experiences of the 1970s led many countries to adopt hierarchical mandates prioritizing inflation stabilization (e.g., New Zealand, Canada).

Summary of Chapter 13, Part 2

  • Necessity of active monetary policy is contingent on:
    • Price stickiness
    • Expectation formations
    • Policy lag lengths
  • In long-term economics, the MP curve predominantly impacts inflation levels, while demand-pull and cost-push mechanisms articulate common inflation scenarios.