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Extending the Textbook Dynamic AD-AS Modern Economy, 2013, 4, 145-160 doi:10.4236/me.2013.43017 Published Online March 2013 (http://www.scirp.org/journal/me) 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 Sami Alpanda1#, Adam Honig2, Geoffrey Woglom2 1Canadian Economic Analysis Department, Bank of Canada, Ottawa, Canada 2Department of Economics, Amherst College, Amherst, USA Email: #[email protected], [email protected], [email protected] Received December 29, 2012; revised January 29, 2013; accepted February 25, 2013 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 pre- sented 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 Taylor rule, 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 analy- sis 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. Keywords: Dynamic AD-AS; Inflation Expectations; Optimal Monetary Policy; Liquidity Trap 1. Introduction relevant as monetary policy is now typically communi- cated in terms of a short-term interest rate and, in some For many decades, the teaching of business cycles has cases, a medium-run inflation target. been dominated by the investment savings—liquidity To overcome these drawbacks, many popular text- money (IS-LM) model whereby monetary policy is books for undergraduate macroeconomics have recently summarized using an exogenous level of the money sup- adopted the dynamic aggregate demand-aggregate supply ply (Hicks [2])1. Although this model has served well in (DAD-DAS) framework to analyze business cycle fluc- many respects, it has often created confusion among stu- tuations and the effects of monetary policy (c.f. Jones [4]; dents regarding the distinction between deflation and Mankiw [1]; Mishkin [5]). The change in the treatment disinflation because of its emphasis on the price level of business cycles found in textbooks has paralleled a rather than the inflation rate. It has also become less burgeoning pedagogical literature that presents alterna- *The views expressed in this paper are solely those of the authors. No tives to the traditional Keynesian IS-LM/AD-AS frame- responsibility for them should be attributed to the Bank of Canada. work that are suitable for undergraduates (Bofinger, #Corresponding author. Mayer, Wollmershäuser [6]; Carlin and Soskice [7]; 1Although early expositions of the IS-LM model were static, later ver- sions have discussed dynamic adjustment of the economy to a long-run Kapinos [8]; Romer [9]; Weerapana [10]; Weisse [11]). equilibrium identified with a full-employment level of output. This These developments have brought the undergraduate long-run adjustment is achieved through adjustment in the price level. treatment of business cycle fluctuations much closer to This also renders the model consistent with long-run neutrality of money as prices increase proportional to the increase in the money the research frontier where monetary policy is modeled supply in the long-run (Abel, Bernanke and Croushore [3]). as an interest rate rule and the analysis is undertaken in Copyright © 2013 SciRes. ME 146 S. ALPANDA ET AL. the inflation rate-output gap space. At the research fron- well-anchored) expectations as the limiting cases. tier, New Keynesian dynamic stochastic general equilib- The paper makes several other contributions to the rium (DSGE) models have become the workhorse of pedagogical literature on dynamic AD-AS models. First, business cycle analysis and monetary economics (c.f. we include a shock to the risk-premium on the interest Smets and Wouters [12]). In their simplest form, these rate relevant for demand relative to the policy rate set by models can be summarized by three equations: an IS the Central Bank. The inclusion of risk shocks is becom- curve relating the output gap to the real interest rate, a ing standard in medium-scale DSGE models and allows Taylor rule summarizing how the nominal interest rate is for a discussion of the recent financial crisis (c.f. Ber- determined by the Central Bank as a reaction to the pre- nanke, Gertler, Gilchrist [18]; Gilchrist, Ortiz, Zakrajsek vailing inflation rate and output gap, and finally a Phil- [19]; Alpanda [20]). lips curve expression which relates current inflation to Second, we allow for more flexibility in the way expected inflation and the output gap (c.f. Gali [13]; monetary policy is conducted by allowing for deviations Clarida, Gali and Gertler [14]). The first two can be com- from the Taylor rule. Our specification allows for mone- bined to obtain an aggregate demand expression in the tary policy to fully offset demand shocks as prescribed inflation-output gap space, and the Phillips curve pro- by optimal policy (Clarida, Gali and Gertler [14]). It also vides the corresponding aggregate supply curve (Kulish allows for partial offsetting of demand shocks in the and Jones [15]). Although modern variants of these DSGE short-run and full offsetting in the long-run, which ar- models feature many layers of complexity, their skeleton guably provides for a more realistic description of actual is still comprised of these three familiar equations2. monetary policy. This partial adjustment in the short-run To achieve the leap from the three-equation DSGE may capture the unwillingness of the Central Bank to model to simpler models suitable for undergraduates change interest rates too quickly. It could also capture the found in textbooks and the recent pedagogical literature, learning process on the part of the Central Bank regard- several simplifications are used. Most importantly, infla- ing the extent of the demand shock. The full-offsetting in tionary expectations are typically assumed to be deter- the long-run also provides a realistic model of the Central mined with adaptive expectations (Jones [4]; Mankiw [1]; Bank’s response to permanent demand shocks that rein- Carlin and Soskice [7]; Kapinos [8]; Weisse [11]). This forces the pedagogical point that competent Central has important implications in terms of generating high Banks can achieve their objectives in the long-run. inflation persistence with temporary shocks and impos- Third, we impose a constraint that the nominal interest ing high output costs to disinflationary programs. Also, rate cannot become negative (i.e. the zero-bound on the in this framework, a positive temporary demand shock nominal interest rate). When faced with a large increase leads initially to a positive output gap and a rise in infla- in the risk-premium (or a large decline in demand), the tion, but then several periods of negative output gaps as Central Bank becomes unable to fully offset this shock the adverse effects of higher inflation on the aggregate due to the zero-bound. We illustrate this liquidity trap supply curve continue to reverberate after the positive situation, faced by the Federal Reserve during the recent impact of demand has subsided. Imposing rational ex- financial crisis, using simulations from our model3. We pectations would overcome these issues, but would sub- also show how the adverse developments during a liquid- stantially complicate the analysis and is typically ignored. ity trap (such as negative output gap and possible defla- In this paper, we extend the DAD-DAS model of tion) can be partially counteracted by the Central Bank Mankiw [1] to include a more flexible form of inflation by credibly raising the inflation target only temporarily. expectations. In particular, we allow inflation expecta- The temporary increase in the inflation target raises ex- tions to be determined as a weighted average of past in- pected inflation and reduces the real interest rate even flation and the inflation target. This brings the treatment when the nominal interest rate is stuck at the zero-bound. closer to rational expectations whereby disinflation can This reduces the adverse impact of the risk shock on the be costless if the decrease in the inflation target is credi- real interest rate relevant for demand. Note however that ble. This framework also allows us to consider alterna- the desirability of temporary changes in the inflation tar- tive forms of expectations formation simply by changing get is a point of contention in Central Banks because it the weight,
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