ECON 302: Intermediate Macroeconomic Theory (Spring 2012-13)

Solution to Discussion Section Week 111  April 12, 2013

CHAPTER 13: STABILIZATION POLICY AND THE AS/AD FRAMEWORK

The short-run model consists of three basic equations as follows:

Ỹt = a − b (Rt − r) (IS)

Rt − r = m (πt − π) (MP)
πt = πte + v Ỹt + o (PC)

The (IS) equation is IS curve. The (MP) equation is monetary policy rule, or Taylor rule. The (PC) equations
is the Phillips curve.

(a) Derive the Aggregated Demand curve nd plot in the graph with Ỹt and πt on the X-axis and Y-axis,
respectively.
Solution:
Take (MP) and substitute into (IS) to receive:

Ỹt = a − b [m (πt − π)]

Ỹt = a − bm (πt − π) (AD)

(b) Derive the Aggregated Supply curve using adaptive expectation and plot it as in (a).
Solution:
Assuming adaptive expectation means that πte = πt−1 . The (PC) itself is already the Aggregated Supply
(AS) curve, so:
πt = πt−1 + v Ỹt + o (AS)
The plot of AD-AS diagram is shown:

πt
AS

πt

AD
Ỹ t Ỹ t

1 The handout for this week is courtesy of your other TA, Wontae Han. Solution and some additional explanation are prepared

by Kanit Kuevibulvanich. This version: April 12, 2013. Comments welcomed.

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Notes: Shifts and slopes of AD and AS (This is useful as this chapter is full of shifting curves!)
(AD) The increase in a, the exogenous demand shock, causes the AD curve to shift right. The higher b,
sensitivity of investment to interest rate, the atter the AD curve. (Since the slope of AD curve is 1/bm.)
The higher m, the aggressiveness of central bank in combating ination, the atter the AD curve. The
increase in π , higher target ination, causes the AD curve to shift right.
(AS) This increase in πte , the expected ination, causes the AS curve to shift up. The higher v , the steeper
the AS curve. (Since the slope of AS curve is v .) The increase in o, the cost-push shock, causes the AS curve
to shift up.

(WARNING: HEAVY ALGEBRA FROM THIS POINT ONWARDS!)

In the following short-answer questions, assume people are making adaptive expectations on the ination.

(c) Verify that in the equilibrium: πt = 1

π
1+vbm t−1
+ vbm
1+vbm
π + v
1+vbm
a + 1
1+vbm
o.
Solution:
Take (AD) and substitute into (AS) to receive:
 
πt = πt−1 + v a − bm (πt − π) + o
= πt−1 + va − vbm (πt − π) + o

Regroup the terms of πt :

1 + vbm πt = πt−1 + va + vbmπ + o
Divide through by 1 + vbm to receive what we wish to show:

1 vbm v 1
πt = πt−1 + π+ a+ o (1)
1 + vbm 1 + vbm 1 + vbm 1 + vbm
Some intuition:
If the economy has no demand or cost-push shock, so a = 0 and o = 0, then today's ination is the weighted
average of expected ination (recall that πte = πt−1 ) and target ination.

(d) Verify that in the equilibrium: πt+1 − π = 1

1+vbm
(πt − π) + v
1+vbm
a + 1
1+vbm
o.
Solution:
Take the expression in part (c), then shift the time forward by one period, namely t becomes t + 1:

1 vbm v 1
πt+1 = πt + π+ a+ o
1 + vbm 1 + vbm 1 + vbm 1 + vbm
Subtract π to both sides and regroup the fraction in parentheses:
 
1 vbm v 1
πt+1 − π = πt + −1 π+ a+ o
1 + vbm 1 + vbm 1 + vbm 1 + vbm
 
1 −1 v 1
= πt + π+ a+ o
1 + vbm 1 + vbm 1 + vbm 1 + vbm
Grouping the coecient to receive what we wish to show that:
1 v 1
πt+1 − π = (πt − π) + a+ o (2)
1 + vbm 1 + vbm 1 + vbm
Some intuition:
If the economy has no demand or cost-push shock, so a = 0 and o =
0, then the gap of ination from target
will be smaller over time. This is due to the fact that 1/ 1 + vbm < 1, so the gap at time t + 1 is smaller
than the gap at time t. Thus, ination converges to the target ination rate.
h i
(e) Verify that in the equilibrium: Ỹt = a − bm 1+vbm
1 v
(πt−1 − π) + 1+vbm 1
a + 1+vbm o

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Solution:
Take the expression in part (d), then the time backward by one period, namely t + 1 becomes t:
1 v 1
πt − π = (πt−1 − π) + a+ o
1 + vbm 1 + vbm 1 + vbm
Substitute into (AD) to receive the expression we wish to show that:
 
1 v 1
Ỹt = a − bm (πt − π) + a+ o
1 + vbm 1 + vbm 1 + vbm

(e2) Show another expression for the output gap in class as: Ỹt = 1
1+vbm
a − bm
1+vbm
(πt−1 − π + o).
Solution:
Take (AS) and substitute into (AS) to receive:
 
Ỹt = a − bm πt−1 + v Ỹt + o − π
= a − bm (πt−1 − π + o) − vbmỸt

Regroup the terms of Ỹt :

1 + vbm Ỹt = a − bm (πt−1 − π + o)
Divide through by 1 + vbm to receive what we wish to show:

1 bm
Ỹt = a− (πt−1 − π + o) (3)
1 + vbm 1 + vbm
Some intuition:
From previous chapters, one may have thought that when there is an exogenous demand shock, a, then
output gap would increase by a one-for-one. However, this is not the case, since the demand shock also
pushes up the ination and central bank does not want this. So, the central bank increases Rt , which slows
down the investment and the output gap, i.e.:

a ↑=⇒ Ỹt ↑=⇒ πt ↑=⇒ Rt ↑=⇒ It ↓=⇒ Ỹt ↓=⇒ πt ↓

Hence, the increase in output gap is less than one-for-one.

(END OF HEAVY ALGEBRA)

In the following short-answer questions, assume the short-run output Ỹt−1 = 0 at time t − 1 and parameters
are given by r = 4%, m = 1, b = 1, v = 1, π = 4% and o = 0. Suppose there is a one-time demand shock at
time t, that is 0 = . . . = at−1 = at+1 = . . . = 0 but at = 1.

With the parameters outlined above, equation (1), (2) and (3) from part (c), (d) and (e) become:
1 1
πt = πt−1 + 2 + a (4)
2 2
1 1
πt+1 − π = (πt − 4) + a (5)
2 2
1 1
Ỹt = a − (πt−1 − 4) (6)
2 2
Equation (4) describes the ination level. Equation (5) describes the dynamic gap of ination rate from
target over the time. Equation (6) describes output gap.

(f) Find out the numerical value for πt−1 and describe the AD-AS curve at time t − 1 by using graph.
Solution:
Take (AD) curve with the parameters at time t − 1 and note that at−1 = 0, so Ỹt−1 = − (πt−1 − 4). Since
Ỹt−1 = 0, then πt−1 = 4. This is intuitive, since there is nothing wrong with the economy, no demand shock,
then ination is whatever the central bank is targeting.

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On AD-AS diagram, the economy at time t − 1 is initialized at point A. Denote the AD and AS curves as
AD(t − 1) and AS(t − 1). They intersect at point A where Ỹt−1 = 0 and πt−1 = 4.

(g) Find out the numerical value for πt and Ỹt . Describe the AD-AS curve at time t by using graph.
Solution:
Note that πt−1 = 4% and at = 1. Take equation (4), so: πt = 12 (4) + 2 + 12 = 4.5%. (You may use equation
(5) to nd πt as well.) Take equation (6), so: Ỹt = 12 − 12 (4 − 4) = 0.5%.
You may wonder why the output gap does not go up to 1%. Since the central bank does not like ination,
so she raises the interest rate to moderate the ination. You can gure out the interest rate by the Taylor
rule (MP) as Rt − 4 = πt − 4, since πt = 4.5%, then Rt = 4.5%. Hence, it can be summarized by:
a ↑=⇒ Ỹt ↑=⇒ πt ↑=⇒ Rt ↑=⇒ It ↓=⇒ Ỹt ↓.
On AD-AS diagram, the economy at time t has positive demand shock, so AD curve shifts right since a
increases, denoted by AD(t). The AS curve remains the same as at time t − 1, denoted by AS(t). They
intersect at point B where Ỹt = 0.5 and πt = 4.5.

(h) Find out the numerical value for πt+1 and Ỹt+1 . Describe the AD-AS curve at time t + 1 by using graph.
Solution:
Note that πt = 4.5% and at+1 = 0, since there is no demand shock anymore. Take equation (4), so:
πt+1 = 12 (4.5) + 2 = 4.25%. Take equation (6), so: Ỹt = − 12 (4.5 − 4) = −0.25%.
You may wonder why the output gap is now negative. This is because, although the demand shock disappears,
the expected ination (πt+1
e
, which is πt ) is still high. You can gure out the interest rate by the Taylor rule
(MP) as Rt − 4 = πt − 4, since πt = 4.25%, then Rt = 4.25%.
To see this more clearly, on AD-AS diagram, the economy at time t + 1 has no positive demand shock, so
AD curve shifts back to the original which is the same as AD(t − 1) when a = 0, denoted by AD(t + 1). The
AS curve, however, shifts up as the expected ination is πt+1 e
= πt = 4.5% which is greater that πt−1 = 4%,
denote this new AS curve by AS(t + 1). They intersect at point C where Ỹt = −0.25 and πt = 4.25.
As a general note to equation (5), ination goes up to 4.5% at time t from the original path of 4%, then
it gradually reduces by half the distance from target period-by-period, namely, to 4.25%, 4.125%, etc. This
shows that the gap of ination from target is smaller over time.

πt
AS(t-1),(t)

4.5 B
C
4.25

4 A

AD(t)

AD(t-1),(t+1)

-0.25 0 0.5 Ỹ t

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EXTRA EXERCISE
Question 1 (The Monetary Policy Rule)
From the Fisher equation it = Rt + πt , solve for the policy interest rate (rule) in the following cases:
(a) If the central banker responds only to ination, namely, Rt − r = m (πt − π).
Solution:
Rearrange the Taylor rule as Rt = r + m (πt − π). From Fisher equation, substitute Rt to receive that:

it = r + m (πt − π) + πt

(b) If the central banker responds to both ination and output gap, namely, Rt − r = m (πt − π) + nỸt .
Solution:
Rearrange the Taylor rule as Rt = r + m (πt − π) + nỸt and substitute into Fisher equation:

it = r + m (πt − π) + nỸt + πt

The monetary policy rule, the response in this example, is called Taylor rule.