Using the ADEASR Model

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Using the ADE/ASR Model

• Chapter 12, Section 3

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Whats the point of using the model?

• To gain a deeper analytical understanding of what
  determines the overall condition of the economy
• Especially output and inflation
• To provide a framework to suggest and assess
  policies designed to improve this condition

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Quick review ADE

• A curve that shows how a change in the inflation
  rate will change aggregate expenditures on all
  goods and services in an economy
• Derived from a FEDs reaction rule
• If -? ? r? the FEDs reaction? AD? shift
  downward on Keynesian Cross diagram ? ADE ?
  movement along it
• Shifters
• ?AEXP
• ?FEDs reaction rule

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Figure 12.2 Changing AD Equilibrium due to the
Fed Reaction
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Quick Review ASR

• A curve that specifies how a shift in ADE affects
  price inflation and real output.
• Demand will create its own supply -- a seeming
  reverse of Says Law
• 3 regimes recession, full employment, maximum
  capacity
• Shifters
• ?inflationary expectations
• Supply shocks

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A
B
C
Figure 12.6 The Aggregate Supply Response (ASR)
Curve
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Various scenarios
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Condition Recession fig 12.9
Recessionary gap
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Policy Reaction

• Employ expansionary policy
• Fiscal policy
• Kennedy example in the book (1964 tax cuts)
• Roosevelt the Great Depression WWII
• Monetary policy
• FEDs reaction to 2001 recession

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Condition Overheated economy
Inflationary gap
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Policy reaction

• Cause of overheating inappropriate fiscal policy
• Vietnam war expenditures increases mid- to
  late-1960s
• Result wage/price spiral
• Johnson temporary tax increase 1968
• Nixon price controls early 1970s
• Rising inflationary expectations
• Ford WIN

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Figure 12.15 Contractionary Fiscal Policy and
Rising Inflationary Expectations
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U.S. economic history with the ADE/ASR model
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Condition Oil price shock pending today, too?
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Policy response

• Monetary fiscal policy work on demand not
  supply helpless here
• ASR must shift downward
• Will a recession reduce inflationary expectations?

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Volckers tight money

• Phillips curve shows inflation rate very high in
  late 1970s.
• Then FED Chair Paul Volcker decided to fight it

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Figure 12.19 Unemployment and Inflation in the
United States 1963-1983
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Unemployment Rate
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Figure 12.20 The Immediate Effect of a Lowered
Inflation Target
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Macro performance in your lifetimes
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Macro performance in your lifetime
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Figure 12.24 The Effects of Technological
Innovation
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Policy response

• Clinton reduced the size of Federal government
  spending from about 22 of GDP to 18
• The FED allowed the unemployment rate to fall
• But interest rates were kept historically high

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Which Presidential Era was best?

• 1961-68 Kennedy/Johnson
• 1969-76 Nixon/Ford
• 1977-80 Carter
• 1981-92 Reagan/Bush
• 1993-2000 Clinton
• Pollin, Contours of Descent, p.35

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No fault