Macroeconomics
Lecture 14: dynamic AS-AD model, part three
Yunho Cho
Spring, 2024
This lecture
• Dynamic AS-AD model, part three: monetary policy implications
– Mankiw “A dynamic model of aggregate demand and aggregate
supply” Sections 14.2–14.3
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This lecture
• Using the dynamic AS-AD model, some examples
– change in inflation target, π ∗
• Monetary policy applications
(i) trade-off between output and inflation variability
(ii) importance of the Taylor principle
2
Change in inflation target π ∗
• Suppose π ∗ reduced from 2% to 1%
• Current inflation above new target, nominal and real rates rise
• New DAD curve at t shifted in from previous DAD curve at t − 1, on
impact DAS curve is unchanged
– on impact, inflation πt is lower and output Yt is lower
(disinflationary recession)
• As inflation falls from t to t + 1, new DAS curve at t + 1 is shifted
down (inflation expectations adjust), output rises as move along
new DAS curve
3
Change in inflation target π ∗
4
Impulse response to change in inflation target π ∗
5
Tradeoff between output and inflation volatility
• No long-run trade-off between output and inflation levels
(in long-run, π = π ∗ and Yt = Ȳ )
• But trade-off between output and inflation volatility
• Choice of monetary policy rule parameters makes for either
relatively more inflation volatility or relatively more output volatility
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Tradeoff between output and inflation volatility
• Slope of DAD curve determines whether supply shock vt has large
effect on inflation or large effect on output
• Flat DAD implies large change in output, small change in inflation
• Steep DAD implies small change in output, large change in inflation
• Slope of DAD curve determined by monetary policy rule
αθπ 1
Yt = Ȳ − (πt − π ∗ ) + εt (DAD)
1 + αθY 1 + αθY
so
dπt 1 + αθY
=−
dYt αθπ
Large θπ makes DAD flat, inflation variance is small, output
variance is large. Large θY makes DAD steep, inflation variance is
large, output variance is small
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Flat or steep DAD curve
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The Fed vs. the European Central Bank
• The monetary policy parameters (θπ , θY ) affect the volatility of
inflation and output
• The U.S. Federal Reserve: a dual mandate, its goal is
– “to promote effectively the goals of maximum employment, stable
prices, and moderate long-term interest rates”
• The European Central Bank:
– “the primary objective of the ECB’s monetary policy is to maintain
price stability”
• In response to the Global Financial Crisis, the Fed lowered interest
rates much more than the ECB did ⇒ more variable output and
more stable inflation in Europe?
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Importance of the Taylor principle
• Monetary policy rule
it = πt + ρ + θπ (πt − π ∗ ) + θY (Yt − Ȳ ), θπ , θY > 0
• Recall “Taylor principle”: policy rule should be such that nominal
interest rate increases more than one for one with inflation, that is
dit
= 1 + θπ > 1 ⇔ θπ > 0
dπt
If so, increase in nominal rate will also increase real rate
• Ensures DAD is downward sloping
αθπ 1
Yt = Ȳ − (πt − π ∗ ) + εt (DAD)
1 + αθY 1 + αθY
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Unstable inflation dynamics if θπ < 0
11
Next lecture
• Rules vs. discretion in macroeconomic policy making
(an application of game theory in macroeconomics)
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