Extending the Textbook Dynamic AD-AS Framework with Flexible Inflation Expectations, Optimal Policy Response to Demand Changes, and the Zero-Bound on the Nominal Interest Rate

Affiliation(s)

Canadian Economic Analysis Department, Bank of Canada, Ottawa, Canada.

Department of Economics, Amherst College, Amherst, USA.

Canadian Economic Analysis Department, Bank of Canada, Ottawa, Canada.

Department of Economics, Amherst College, Amherst, USA.

ABSTRACT

Many popular macroeconomics textbooks have recently adopted the dynamic aggregate demand-aggregate supply framework to analyze business cycle fluctuations and the effects of monetary policy. This brings the textbook treatment much closer to the research frontier, although a major remaining difference is the treatment of inflation expectations. Textbook treatments typically assume adaptive expectations for tractability. In this paper, we extend the model presented in Mankiw [1] by incorporating a more flexible form of expectation formation that is determined as a weighted average of past inflation and the inflation target. This brings the treatment closer to rational expectations and allows for a discussion of costless disinflation. Monetary policy is assumed to follow a Taylorrule, but we allow for deviations from the rule to motivate a discussion regarding optimal monetary policy response to demand shocks. We also include a shock to the risk-premium on the interest rate relevant for demand relative to the policy rate set by the Central Bank, and impose the zero-bound on the nominal interest rate in the solution of the model. These features allow for the analysis of the recent financial crisis, monetary policy falling into a liquidity trap, and the desirability of a temporary increase in the inflation target. Finally, we make available an Excel sheet with which students can analyze the effect of shocks to the economy using impulse responses and dynamic aggregate demand-aggregate supply diagrams.

Cite this paper

S. Alpanda, A. Honig and G. Woglom, "Extending the Textbook Dynamic AD-AS Framework with Flexible Inflation Expectations, Optimal Policy Response to Demand Changes, and the Zero-Bound on the Nominal Interest Rate,"*Modern Economy*, Vol. 4 No. 3, 2013, pp. 145-160. doi: 10.4236/me.2013.43017.

S. Alpanda, A. Honig and G. Woglom, "Extending the Textbook Dynamic AD-AS Framework with Flexible Inflation Expectations, Optimal Policy Response to Demand Changes, and the Zero-Bound on the Nominal Interest Rate,"

References

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[19] S. Gilchrist, A. Ortiz and E. Zakrajsek, “Credit Risk and the Macroeconomy: Evidence from an Estimated DSGE Model,” Boston University, Boston, 2009.

[20] S. Alpanda, “Identifying the Role of Risk Shocks in the Business Cycle Using Stock Price Data,” Economic Inquiry, Vol. 51, No. 1, 2013, pp. 304-335. doi:10.1111/j.1465-7295.2011.00445.x

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[28] J. B. Taylor, “Discretion versus Policy Rules in Practice,” Carnegie-Rochester Conference Series on Public Policy, Vol. 39, No. 1, 1993, pp. 195-214. doi:10.1016/0167-2231(93)90009-L

[1] N. G. Mankiw, “Macroeconomics,” 7th Edition, Worth Publishers, London, 2010.

[2] J. Hicks, “Mr. Keynes and the ‘Classics’: A Suggested Interpretation,” Econometrica, Vol. 5, No. 2, 1937, pp. 147-159. doi:10.2307/1907242

[3] A. Abel, B. Bernanke and D. Croushore, “Macroeconomics,” 7th Edition, Prentice Hall, Upper Saddle River, 2010.

[4] C. I. Jones, “Macroeconomics,” 2nd Edition, W.W. Norton and Co., New York, 2010.

[5] F. S. Mishkin, “Macroeconomics: Policy and Practice,” Prentice Hall, Upper Saddle River, 2011.

[6] P. Bofinger, E. Mayer and T. Wollmersh?user, “The BMW Model: A New Framework for Teaching Monetary Economics,” Journal of Economic Education, Vol. 37, No. 1, 2006, pp. 98-117. doi:10.3200/JECE.37.1.98-117

[7] W. Carlin D. Soskice, “The 3-Equation New Keynesian Model—A Graphical Exposition,” Contributions to Macroeconomics, Vol. 5, No. 1, 2005, pp. 1-36.

[8] P. Kapinos, “A New Keynesian Workbook,” International Review of Economics Education, Vol. 9, No. 1, 2010, pp. 111-123.

[9] D. Romer, “Keynesian Macroeconomics without the LM Curve,” Journal of Economic Perspectives, Vol. 14, No. 2, 2000, pp. 149-169.

[10] A. Weerapana, “Intermediate Macroeconomics without the IS-LM Context,” Journal of Economic Education, Vol. 34, No. 33, 2003, pp. 241-262. doi:10.1080/00220480309595219

[11] C. Wiese, “A Simple Wicksellian Macroeconomic Model,” The B.E. Journal of Macroeconomics, Vol. 7, No. 1, 2007, Article 11.

[12] F. Smets and R. Wouters, “Shocks and Frictions in US Business Cycles: A Bayesian DSGE Approach,” American Economic Review, Vol. 97, No. 3, 2007, pp. 586-606. doi:10.1257/aer.97.3.586

[13] J. Gali, “Monetary Policy, Inflation, and the Business Cycle: An Introduction to the New Keynesian Framework,” Princeton University Press, Princeton, 2008.

[14] R. Clarida, J. Gali and M. Gertler, “The Science of Monetary Policy: A New Keynesian Perspective,” Journal of Economic Literature, Vol. 37, 1999, pp. 1661-1707. doi:10.1257/jel.37.4.1661

[15] M. Kulish and C. Jones, “A Graphical Representation of an Estimated DSGE Model,” Dynare Working Papers Series #3, 2011.

[16] F. Kydland and E. C. Prescott, “Time to Build and Aggregate Fluctuations,” Econometrica, Vol. 50, No. 6, 1982, pp. 1345-1371. doi:10.2307/1913386

[17] C. E. Tovar, “DSGE Models and Central Banks,” Kiel Institute for the World Economy, Economics Discussion Papers 2008-30, 2008.

[18] B. S. Bernanke, M. Gertler and S. Gilchrist, “The Financial Accelerator in a Quantitative Business Cycle Framework,” In: J. B. Taylor and M. Woodford, Eds., Handbook of Macroeconomics, Elsevier Science, Amsterdam, 1999, pp. 1341-1393.

[19] S. Gilchrist, A. Ortiz and E. Zakrajsek, “Credit Risk and the Macroeconomy: Evidence from an Estimated DSGE Model,” Boston University, Boston, 2009.

[20] S. Alpanda, “Identifying the Role of Risk Shocks in the Business Cycle Using Stock Price Data,” Economic Inquiry, Vol. 51, No. 1, 2013, pp. 304-335. doi:10.1111/j.1465-7295.2011.00445.x

[21] P. Bofinger and S. Debes, “A Primer on Unconventional Monetary Policy,” CEPR Discussion PAPER: No. 7755, 2010.

[22] P. Kapinos, “Liquidity Trap in an Inflation-Targeting Framework: A Graphical Analysis,” International Review of Economics Education, Vol. 10, No. 2, 2011, pp. 91-105.

[23] M. Woodford, “Interest and Prices,” Princeton University Press, Princeton, 2003.

[24] G. Calvo, “Staggered Prices in a Utility Maximizing Framework,” Journal of Monetary Economics, Vol. 12, No. 3, 1983, pp. 383-398. doi:10.1016/0304-3932(83)90060-0

[25] J. B. Taylor, “Aggregate Dynamics and Staggered Contracts,” Journal of Political Economy, Vol. 88, No. 1, 1980, pp. 1-23. doi:10.1086/260845

[26] J. Rotemberg, “Monopolistic Price Adjustment and Aggregate Output,” Review of Economic Studies, Vol. 49, No. 4, 1982, pp. 517-531. doi:10.2307/2297284

[27] O. J. Blanchard and C. M. Kahn, “The Solution of Linear Difference Models under Rational Expectations,” Econometrica, Vol. 48, No. 5, 1980, pp. 1305-1311. doi:10.2307/1912186

[28] J. B. Taylor, “Discretion versus Policy Rules in Practice,” Carnegie-Rochester Conference Series on Public Policy, Vol. 39, No. 1, 1993, pp. 195-214. doi:10.1016/0167-2231(93)90009-L