ADEASR Model

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ADE/ASR Model Inflation

• Chapter 12, Sections 1 2

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Whats an economy for?

• Well-being
• Promoting the sustenance and flourishing of life
  Chapter 1
• Feasible goals
• Smooth growth of real GDP
• Low unemployment rate
• Low inflation rate

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New concept Aggregate Demand Equilibrium ADE

• AD assumed prices were constant
• Keynesian Cross diagram
• ADE is derived from AD where prices change
• ADE C I G NX, but we are now partnering
  up with price inflation
• ADE also adds two assumptions about FED behavior
• Stabilizes real output smooth out the bs. cycle
• Stabilizes prices keep inflation low

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Derivation of ADE curve

• Process is similar to your previous knowledge
• Interest rate? ? II? ? AD shift down
• Here we simply link changes in interest rates to
  a FED reaction rule when the inflation rate
  changes
• If inflation rate??

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Figure 12.1 The Fed Reaction Rule
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Figure 12.2 Changing AD Equilibrium due to the
Fed Reaction
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New key conceptual idea

• As the inflation rate rises (-) ? income (Y)
  falls
• As does real output fall, since they are the
  same thing
• This can be captured by a graph Figure 12.3

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Figure 12.3 The Aggregate Demand Equilibrium Curve
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Movement along ADE vs. shift of ADE

• Old principles in a new context
• If inflation rate changes ? a movement along the
  ADE
• A change in the quantity demanded of output
• If anything else changes ? a shift of the ADE
• A change in ADE

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Figure 12.4 The Effect of Expansionary Fiscal
Policy or Increased Confidence
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What are those shifters?

• Changes in autonomous expenditures
• Auto C changed consumer confidence
• Auto I changed bs. confidence
• Auto G changed fiscal policy
• Auto NX changes from abroad
• Changes in the FEDs target inflation rate

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Figure 12.5 The Effect of a Lower Target
Inflation Rate
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easy policy
-
tight policy
r0
Y0
Figure 12.5 The Effect of a Lower Target
Inflation Rate
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Exercise/No Fault

• Looking at ADE

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The Supply Side

• Capacity and the ASR

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Aggregate Supply Response

• Key word response
• As ADE becomes stronger (shifts outward), how
  does the inflation rate react?
• A. Recession ? sticky prices (little change)
• Lots of excess capacity (hi UR low capital
  utilization)
• B. Full employment ? strong pressure for
  inflation
• At or approaching full capacity (bottlenecks
  occur)
• C. Boom ? inflation rate spiraling upward
• Beyond full capacity

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A
B
C
Figure 12.6 The Aggregate Supply Response (ASR)
Curve
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ASR Movement vs. shift

• Same principles again
• If inflation rate changes ? movement along ASR
• If anything else changes ? shift of ASR
• Inflationary expectations Fig 12.7
• Supply shocks
• Beneficial Fig 12.8 new oil fields in Brazil
• Adverse Iraq economy Bangladesh

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Figure 12.7 An Increase in Inflationary
Expectations
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Figure 12.8 A Beneficial Supply Shock
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Exercise

• Exercise 1, page 12-32

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Figures Tables
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Figure 12.10 Unemployment and Inflation in the
United States, 1963-1965
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Figure 12.12 Unemployment and Inflation in the
United States, 1963-1969
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Figure 12.14 Unemployment and Inflation in the
United States, 1963-1973
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Figure 12.16 Unemployment and Inflation in the
United States, 1963-1976
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12.18 Medium-Run Adjustment to the Oil Price Shock
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Figure 12.21 The Medium-Run Effect of a Lowered
Inflation Target
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Figure 12.22 Unemployment and Inflation in the
United States, 1983-2004
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Figure 12.23 Unemployment and Inflation in the
United States, 1992-1999
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Figure 12.24 The Effects of Technological
Innovation
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Figure 12.27 Expansionary Monetary Policy with
Rational Expectations