Macroeconomic Theory

(chapter 15)

A Dynamic Model of Aggregate

Demand and Aggregate Supply
 Introduction
• We now present a model that explicitly describes
the evolution of the economy over time.
• This is the dynamic model of aggregate demand
and aggregate supply (DAD-DAS) determining the
time path
– real GDP (Y), and
– the inflation rate (π)
• This theory is dynamic in the sense that the
outcomes in one period affect outcomes in the
next period
 The DAS-DAD model provides
• A unified framework linking IS to the
Phillips curve.

• Describe central bank policies in the form

of interest rate targets

• An explicit time notion, so we can speak

about the duration of business cycles and
the response of the economy to shocks.
 Basic concepts
• Instead of representing monetary policy by an
exogenous money supply, the central bank will
now be seen as following a monetary policy
rule
– The central bank’s monetary policy rule adjusts
interest rates automatically when output or
inflation are not where they should be.
 Key concepts
• The DAD-DAS model is built on the following
concepts:
– the IS curve, which negatively relates the real interest
rate (r) and demand for goods and services (Y),
– the Phillips curve, which relates inflation (π) to the
gap between output and its natural level (𝑌 − 𝑌), ത
expected inflation (Eπ), and supply shocks (ν),
– adaptive expectations, which is a simple model of
expected inflation,
– the Fisher effect, and
– the monetary policy rule of the central bank.
 Preview: how the dynamic AD-AS model is
different from standard model

P
𝜋
AS DASt

P0
𝜋𝑡

AD DADt
Y0 Y 𝑌𝑡 Y
In the vertical axis we
now have the inflation
rate, DAS and DAD are
indexed by time t
 Keeping track of time
• The subscript “t ” denotes a time period, e.g.
– Yt = real GDP in period t
– Yt − 1 = real GDP in period t – 1
– Yt + 1 = real GDP in period t + 1
• We can think of time periods as years.
E.g., if t = 2008, then
– Yt = Y2008 = real GDP in 2008
– Yt − 1 = Y2007 = real GDP in 2007
– Yt + 1 = Y2009 = real GDP in 2009
 The model’s elements
• The model has five equations and five
endogenous variables:
– output,
– inflation,
– the real interest rate,
– the nominal interest rate,
– and expected inflation.
• The first equation is for output…
The Demand Equation
Natural (or Real Natural (or
long-run or interest long-run)
potential) rate Real interest
Real GDP rate

Yt = Yt −   (rt −  ) +  t
Real Parameter Demand shock,
GDP representing the represents
response of changes in G, T,
demand to the real C0, and I0
interest rates
 The Demand Equation
Assumption: ρ > 0; although the real interest rate can be
negative, in the long run people will not lend their
resources to others without a positive return. This is the
long-run real interest rate we had calculated in Ch. 3

Yt = Yt −   (rt −  ) +  t
α>0 Positive when C0,
I0, or G is higher
Assumption: There is a negative than usual or T is
relation between output (Yt) and lower than usual.
interest rate (rt). The justification is
the same as for the IS curve of Ch. 11
 IS Curve = Demand Equation
• This graph is from Ch. r
A
11 rt

• Assume the IS curve is 𝒓ത

B
a straight line IS
ഥ Y
• Then, for any pair of Yt 𝒀
points—A and B, or C r

and B—the slope C

rt
must be the same 𝒓ത
B
IS
ഥ
Yt 𝒀 Y
 IS Curve = Demand Equation
• Then, for any point (rt, r
Yt) on the line, we get rt
𝑌𝑡 −𝑌ത𝑡
= −𝛼, a constant. 𝒓ത
𝑟𝑡 −𝑟𝑡ҧ
IS
• 𝑌𝑡 − 𝑌ത𝑡 = −𝛼 ∙ 𝑟𝑡 − 𝑟𝑡ҧ Yt ഥ
𝒀 Y
• 𝑌𝑡 = 𝑌ത𝑡 − 𝛼 ∙ 𝑟𝑡 − 𝜌 r

rt
𝒓ത
The long-run real equilibrium interest rate of IS
Figure 3-8 in Ch. 3 is now denoted by the
lower-case Greek letter ρ. ഥ
Yt 𝒀 Y
 IS Curve = Demand Equation
• 𝑌𝑡 = 𝑌ത𝑡 − 𝛼 ∙ 𝑟𝑡 − 𝜌
• Now, we also saw in Ch. 12 that the IS curve can
shift when there are changes in C0, I0, G, and T
• To represent all these shift factors, we add the
random demand shock, εt.
• 𝒀𝒕 = 𝒀ഥ 𝒕 − 𝜶 ∙ 𝒓𝒕 − 𝝆 + 𝝐𝒕
• Therefore, the IS curve of Ch. 12 gives us this
chapter’s demand equation
 IS Curve = Demand Equation
Yt = Yt −   (rt −  ) +  t
rt rt

ρ ρ
IS Demand
ഥ𝐭
𝒀 Yt ഥ
𝒀 Yt

• The IS curve can simply be renamed the

Demand Equation curve
The Real Interest Rate: The Fisher Equation

rt = it − Et  t +1
ex ante
(i.e. expected)
real interest nominal expected
rate interest inflation rate
rate

 t +1 = increase in price level from period t to t +1,

not known in period t
Et  t +1 = expectation, formed in period t,
of inflation from t to t +1

We saw this before in Ch. 5

 Inflation: The Phillips Curve
 t = Et −1  t +  (Yt − Yt ) +  t

current previously supply

inflation expected shock,
inflation random and
zero on
  0 indicates how much average
inflation responds when
output fluctuates around
its natural level
Expected Inflation: Adaptive Expectations

Et  t +1 =  t

For simplicity, we assume people

expect prices to continue rising
at the current inflation rate.
 Monetary Policy Rule
• The fifth and final main assumption of the
DAD-DAS theory is that
– The central bank sets the nominal interest rate
– and, in setting the nominal interest rate, the
central bank is guided by a very specific formula
called the monetary policy rule
 Monetary Policy Rule
Current Parameter that Parameter that
inflation measures how measures how
rate strongly the strongly the
central bank central bank
responds to the responds to
inflation gap the GDP gap

(
it =  t +  +    t −  + Y  (Yt − Yt ) *
t )
Nominal Natural real Inflation Gap: The GDP Gap: The
interest interest rate excess of current excess of current
rate, set inflation over the GDP over natural
each period central bank’s GDP
by the inflation target
central bank
 The Nominal Interest Rate:
The Monetary-Policy Rule

it =  t +  +  ( t −  ) + Y (Yt − Yt )
*
t

measures how much measures how much the

the central bank central bank adjusts the
adjusts the interest interest rate when
rate when inflation output deviates from
deviates from its target its natural rate
 Example: The Taylor Rule
• Economist John Taylor proposed a monetary policy rule
very similar to ours:
iff =  + 2 + 0.5( – 2) – 0.5(GDP gap)
where
– iff = nominal federal funds rate target
Y −Y
– GDP gap = 100 x
Y
= percent by which real GDP is below its natural rate
• The Taylor Rule matches Fed policy fairly well.…
 CASE STUDY
The Taylor Rule
10

9 actual
8 Federal
7
Funds rate

6
Percent

2 Taylor’s
1
rule
0
1987 1989 1991 1993 1995 1997 1999 2001 2003 2005 2007 2009
 Recap: The model’s variables and parameters
• Endogenous variables:

Yt = Output

t = Inflation

rt = Real interest rate

it = Nominal interest rate
Et  t +1 = Expected inflation
 The model’s variables and parameters
• Exogenous variables:
Yt = Natural level of output
 =
*
t Central bank’s target inflation rate

 t = Demand shock
 t = Supply shock
• Predetermined variable:
 t −1 = Previous period’s inflation
 The model’s variables and parameters
• Parameters:
 = Responsiveness of demand to
the real interest rate
 = Natural rate of interest
 = Responsiveness of inflation to
output in the Phillips Curve
 = Responsiveness of i to inflation
in the monetary-policy rule
Y = Responsiveness of i to output
in the monetary-policy rule
 The DAD-DAS Equations

Yt = Yt −   (rt −  ) +  t Demand Equation

rt = it − Et t +1 Fisher Equation

 t = Et −1 t +   (Yt − Yt ) + t Phillips Curve

Et t +1 =  t Adaptive Expectations

( )
it =  t +  +    t −  + Y  (Yt − Yt )
*
t
Monetary Policy Rule
 Next steps

Combine previous equations to derive two

equations in 2 unknowns (𝑌𝑡 , 𝜋𝑡 ):
1. dynamic AS:
 t =  t −1 +   (Yt − Yt ) + t
2. dynamic AD:
𝑌𝑡 = 𝑌ത𝑡 − 𝐴 ∙ 𝜋𝑡 − 𝜋 ∗ 𝑡 + 𝐵 ∙ 𝜀𝑡

Given shocks (𝜈𝑡 , 𝜀𝑡 ), 𝜋 ∗ 𝑡 , and 𝑌ത𝑡 , these equations

fully describe dynamics of output and inflation.
 Step 1: Dynamic Aggregate Supply
 t = Et −1 t +   (Yt − Yt ) + t Phillips Curve

Et t +1 =  t Adaptive Expectations

Et −1 t =  t −1

 t =  t −1 +   (Yt − Yt ) + t DAS Curve

 The Dynamic Aggregate Supply Curve
 t =  t −1 +   (Yt − Yt )+ t
πt DAS slopes upward:
high levels of output
DASt are associated with
high inflation. This is
 t −1 + t because of demand-
pull inflation

DAS shifts in
response to
changes in
Yt ത 𝜋𝑡−1 , 𝜈𝑡
𝑌,
Yt
 Step 2: The Dynamic Aggregate Demand Curve
The Demand Equation

Yt = Yt −  (rt −  ) + t rt = it − Et t +1
Fisher equation

Yt = Yt −  ( it − Et  t +1 −  ) + t
Et t +1 =  t
adaptive
expectations
Yt = Yt −  ( it −  t −  ) + t
 The Dynamic Aggregate Demand Curve

( )
it =  t +  +    t −  + Y  (Yt − Yt )
*
t
monetary policy rule

Yt = Yt −  ( it −  t −  ) + t

Yt = Yt − [  t +  + ( t −  t* ) + Y (Yt − Yt ) −  t −  ] +  t

Yt = Yt − [ ( t −  ) + Y (Yt − Yt )] + t
*
t

We’re almost there!

 The Dynamic Aggregage Demand Curve
From previous slide

Yt = Yt − [ ( t −  t* ) + Y (Yt − Yt )] + t

Solve for 𝑌𝑡

𝑌𝑡 = 𝑌ത𝑡 − 𝐴 ∙ 𝜋𝑡 − 𝜋 ∗ 𝑡 + 𝐵 ∙ 𝜀𝑡 (DAD)

where
𝛼𝜃𝜋 1
𝐴= > 0, 𝐵 = >0
1 + 𝛼𝜃𝑌 1 + 𝛼𝜃𝑌
 The Dynamic Aggregate Demand Curve
𝑌𝑡 = 𝑌ത𝑡 − 𝐴 ∙ 𝜋𝑡 − 𝜋 ∗ 𝑡 + 𝐵 ∙ 𝜀𝑡
π
DAD slopes downward:
When inflation rises, the central bank
raises the real interest rate, reducing the
demand for goods and services.

DAD shifts in response to

changes in the natural level of
output, inflation target, and
DADt demand shock ( 𝑌, ത 𝜋 ∗ , 𝜀𝑡 )

Y
 The short run equilibrium
𝜋
𝑌ത𝑡
DASt
In each period, the
A intersection of DAD and
𝜋t DAS determines the short-
run equilibrium inflation
and output.

DADt

Yt
Y
 The long-run equilibrium
• The DAD curve
𝑌𝑡 = 𝑌ത𝑡 − 𝐴 ∙ 𝜋𝑡 − 𝜋 ∗ 𝑡 + 𝐵 ∙ 𝜀𝑡

• The DAS curve

𝜋𝑡 = 𝜋𝑡−1 + 𝜙 𝑌𝑡 − 𝑌ത𝑡 + 𝜈𝑡

The long-run equailibrium is the steady state around which

the economy fluctuates when 𝜀𝑡 = 𝜈𝑡 = 0 and inflation is
constant 𝜋𝑡 = 𝜋𝑡−1 , which yields
𝑌𝑡 = 𝑌ത𝑡
𝜋𝑡 = 𝜋 ∗ 𝑡
 Short-Run Equilibria Converge to Long-
Run Equilibrium
π Y DAS2002
DAS2003
B DAS2004
π2002
π2003 C
D
π2004 DAS2014

π2013 = π2014
A

DADall years
Y
Y2014
At B, demand is weak so 𝜋 ↓(see DAS eq). As 𝜋 ↓, inflation expectations fall , DAS shifts
↓ (𝜋𝑡−1 decreases in DAS eq). DAD curve does not shift (none of parameters in DAD
equation changes).