N. Gregory Mankiw

SEVENTH EDITION
MACROECONOMICS
N. Gregory Mankiw
PowerPoint® Slides by Ron Cronovich
CHAPTER 14
A Dynamic Model of Aggregate
Demand and Aggregate Supply
© 2010 Worth Publishers, all rights reserved

In this chapter, you will learn:
 how to incorporate dynamics into the
AD-AS model we previously studied
 how to use the dynamic AD-AS model to
illustrate long-run economic growth
 how to use the dynamic AD-AS model to
trace out the effects over time of various
shocks and policy changes on output,
inflation, and other endogenous variables
Introduction
 The dynamic model of aggregate demand and
aggregate supply gives us more insight into how
the economy works in the short run.
 It is a simplified version of a DSGE model,
used in cutting-edge macroeconomic research.
(DSGE = Dynamic, Stochastic, General
Equilibrium)
CHAPTER 14 Dynamic AD-AS Model 3

Introduction
 The dynamic model of aggregate demand and
aggregate supply is built from familiar concepts,
such as:
 the IS curve, which negatively relates the real
interest rate and demand for goods & services
 the Phillips curve, which relates inflation to the
gap between output and its natural level,
expected inflation, and supply shocks
 adaptive expectations, a simple model of
inflation expectations

How the dynamic AD-AS model is
different from the standard model
 Instead of fixing the money supply, the central
bank follows a monetary policy rule that adjusts
interest rates when output or inflation change.
 The vertical axis of the DAD-DAS diagram
measures the inflation rate, not the price level.
 Subsequent time periods are linked together:
Changes in inflation in one period alter
expectations of future inflation, which changes
aggregate supply in future periods, which further
alters inflation and inflation expectations.
Keeping track of time
 The subscript “t ” denotes the time period, e.g.
 Yt = real GDP in period t
 Yt -1 = real GDP in period t – 1
 Yt +1 = real GDP in period t + 1
 We can think of time periods as years.
E.g., if t = 2008, then
 Yt = Y2008 = real GDP in 2008
 Yt -1 = Y2007 = real GDP in 2007
 Yt +1 = Y2009 = real GDP in 2009
The model’s elements
 The model has five equations and five
endogenous variables:
output, inflation, the real interest rate, the
nominal interest rate, and expected inflation.
 The equations may use different notation,
but they are conceptually similar to things
you’ve already learned.
 The first equation is for output…

Output:
The Demand for Goods and Services
Yt  Yt   (rt   )   t
output natural real

  0,   0
level of interest
output rate
Negative
Negative relation
relation between
between output
output and
and interest
interest rate,
rate,
same
same intuition
intuition as
as IS
IS curve.
curve.

Output:
The Demand for Goods and Services
Yt  Yt   (rt   )   t
demand
measures the
shock,
interest-rate “natural rate of random and
sensitivity of interest” – zero on
demand in absence of average
demand shocks,
Yt  Yt when rt  

The Real Interest Rate:
The Fisher Equation
rt  it  Et  t 1
ex ante
(i.e. expected)
real interest nominal expected
rate interest inflation rate
rate
 t 1  increase in price level from period t to t +1,
Et  t 1  not known in period t

expectation, formed in period t,
of inflation from t to t +1
Inflation:
The Phillips Curve
 t  Et 1  t   (Yt  Yt )   t
current previously supply

inflation expected shock,
inflation random and
zero on
  0 indicates how much average
inflation responds when
output fluctuates around
its natural level

Expected Inflation:
Adaptive Expectations
Et  t 1   t
For
For simplicity,
simplicity, we
we assume
assume people
people
expect
expect prices
prices toto continue
continue rising
rising at
at
the
the current
current inflation
inflation rate.
rate.

The Nominal Interest Rate:
The Monetary-Policy Rule
it   t     ( t   )  Y (Yt  Yt )
*
t
nominal central
interest rate, bank’s
set each period inflation
by the central target
bank
natural
rate of
interest
  0, Y  0

The Nominal Interest Rate:
The Monetary-Policy Rule
it   t     ( t   )  Y (Yt  Yt )
*
t
measures how much measures how much the

the central bank central bank adjusts the
adjusts the interest interest rate when
rate when inflation output deviates from
deviates from its target its natural rate

CASE STUDY
The Taylor Rule
 Economist John Taylor proposed a monetary
policy rule very similar to ours:
iff =  + 2 + 0.5 ( – 2) – 0.5 (GDP gap)
where
 iff = nominal federal funds rate target
Y Y
 GDP gap = 100 x Y
= percent by which real GDP is below its
natural rate
 The Taylor Rule matches Fed policy fairly well.…
CASE STUDY
The Taylor Rule
actual
Federal
Funds rate
Taylor’s
rule
The model’s variables and parameters
 Endogenous variables:
Yt  Output
t  Inflation
rt  Real interest rate

it  Nominal interest rate
Et  t 1  Expected inflation

 Exogenous variables:
Yt  Natural level of output
 
*
t Central bank’s target inflation rate
t  Demand shock
t  Supply shock
 Predetermined variable:
 t 1  Previous period’s inflation
 Parameters:
  Responsiveness of demand to
the real interest rate
  Natural rate of interest
  Responsiveness of inflation to
output in the Phillips Curve
  Responsiveness of i to inflation
in the monetary-policy rule
Y  Responsiveness of i to output
in the monetary-policy rule
The model’s long-run equilibrium
 The normal state around which the economy
fluctuates.
 Two conditions required for long-run equilibrium:
 There are no shocks:  t   t  0
 Inflation is constant:  t 1   t

The model’s long-run equilibrium
 Plugging the preceding conditions into the
model’s five equations and using algebra
yields these long-run values:
Yt  Yt
rt  
t  t *
Et  t 1   *
t
it     t
*

The Dynamic Aggregate Supply Curve
 The DAS curve shows a relation between output
and inflation that comes from the Phillips Curve
and Adaptive Expectations:
 t   t 1   (Yt  Yt )   t (DAS)

The Dynamic Aggregate Supply Curve
 t   t 1   (Yt  Yt )   t
π DAS
DAS slopes
slopes upward:
upward:
high
high levels
levels of
of output
output
DASt are
are associated
associated with
with
high
high inflation.
inflation.
DAS
DAS shifts
shifts in
in response
response
to
to changes
changes in in the
the
natural
natural level
level of
of output,
output,
previous
previous inflation,
inflation,
and
and supply
supply shocks.
shocks.
Y

The Dynamic Aggregate Demand Curve
 To derive the DAD curve, we will combine four
equations and then eliminate all the endogenous
variables other than output and inflation.
Start with the demand for goods and services:
Yt  Yt   (rt   )   t
using
using the
the Fisher
Fisher eq’n
eq’n
Yt  Yt   ( it  Et  t 1   )   t

result
result from
from previous
previous slide
slide
Yt  Yt   ( it  Et  t 1   )   t
using
using the
the
expectations
expectations eq’n
eq’n
Yt  Yt   ( it   t   )   t
using
using monetary
monetary
policy
policy rule
rule
Yt  Yt   [  t     ( t   t* )  Y (Yt  Yt )   t   ]   t
Yt  Yt   [ ( t   t* )  Y (Yt  Yt )]   t
result
result from
from previous
previous slide
slide
Yt  Yt   [ ( t   t* )  Y (Yt  Yt )]   t
combine
combine like
like terms,
terms, solve for Y
solve for Y
Yt  Yt  A( t   )  B t ,
*
t
(DAD)
 1
where A  0, B  0
1  Y 1  Y

Yt  Yt  A( t   )  B t
*
t
π
DAD
DAD slopes
slopes downward:
downward:
When
When inflation
inflation rises,
rises, the
the central
central bank
bank
raises
raises the
the real
real interest
interest rate,
rate, reducing
reducing
the
the demand
demand for for goods
goods & & services.
services.
DAD
DAD shifts
shifts in
in response
response
to
to changes
changes in in the
the
natural
natural level
level ofof output,
output,
DADt
the
the inflation
inflation target,
target, and
and
Y demand
demand shocks.
shocks.

The short-run equilibrium
π In
In each
each period,
period, thethe
Yt intersection
intersection ofof DAD
DAD
and
and DAS
DAS determines
determines
DASt the
the short-run
short-run eq’m
eq’m
values
values of
of inflation
inflation
A and
πt and output.
output.
In
In the
the eq’m
eq’m
shown
shown here
here atat A,
A,
DADt
output
output isis below
below
its
its natural
natural level.
level.
Y
Yt

Long-run growth
Period
Period DAS
DAS tt:: shifts
shifts
π Yt Yt +1 initial because
eq’m
initial eq’m at
because at A
A
economy
economy can can
DASt produce
produce more more
DASt +1 g&s
g&s
Period tt ++ 11 ::
Period
πt Long-run
A B New
New eq’m
Long-run
eq’m at
at B,
B,
= πt DAD
DAD
growth
income
growth
shifts
shifts
grows
πt + 1 income
because grows
because
increases the
but
but inflation
increases
inflation the
higher
higher income
income
natural
remains
natural
remains rate
stable.
rate
stable.
raises
raises
of
of output.
output.
DADt DADt +1 demand
demand
Y for
for g&s
g&s
Yt Yt +1

A shock to aggregate supply
Y Periodtttt+
Period
Period
Period :––12211::::
:+
π DASt
Asinitial
Supply
Supply
Asinitial
Supply
Supply eq’m
inflationshock
shock
eq’m
inflationshock
shock at
at A
falls,A
falls,
DASt +1 ((ννover
DASt +2
is >> 0)
inflation
is over
inflation νshifts
0)((shifts
ν == 0) 0)
B DAS
butDAS
but DASupward;
expectations
DAS does
upward;
expectations doesfall, not
not
fall,
πt C inflation
return
DAS
return
DAS to
to its
moves
inflation
moves rises,
rises,
its initial
initial
D
πt + 2 central
central bank
position
downward,
position
downward, due
due to
bank to
DASt -1
responds
higher
output
responds
higher
output inflation
rises.
inflation
rises. by
by
raising
expectations.
raising
expectations.
This real
real
process
πt – 1 A interest
interest rate, rate,
continues until
output falls.
outputreturns
output falls. to
DAD its natural rate.
Y LR eq’m at A.
Yt Yt + 2 Yt –1

Parameter values for simulations
Yt  100 Thus,
Thus, we we can interpret Yt – Yt
can interpret
as
as the
the percentage
percentage deviation
deviation of
of
Central
Centralfrom bank’s
bank’s inflation
inflationlevel.
 t*  2.0 output
A
outputisfrom
target 2
its
1-percentage-point
target is 2 percent.
A 1-percentage-point
natural
its natural level.
percent. increase
increase
The
The following
following graphs
graphs are are called
called
  1.0 in
in the
the real
impulse
impulse real interest
interest rate
response
response rate reduces
reduces
functions.
functions.
output
output
They demand
demand
show the by
by 11 percent
“response”percent of of
of
They
The
The show
natural
natural the
rate “response”
of interest
rate of interest is of
is
  2.0 its
2the
natural
its natural
the endogenous
percent.
level.
endogenous
2 percent.
level. variables to
variables to
When
When output
output is is 1 percent
1 the
percent
the “impulse,” i.e. shock.
  0.25 the
above “impulse,” i.e. the
above its natural level, inflation
its natural level, shock.
inflation
rises
rises by by 0.25
0.25 percentage
percentage point. point.
  0.5 These
These values
values are are from
from thethe Taylor
Taylor
Rule,
Rule, which
which approximates
approximates the the actual
actual
Y  0.5 behavior
behavior of of the
the Federal
Federal Reserve.
Reserve.
The dynamic response to a supply shock
t
AA one-
one-
period
period
supply
supply
shock
shock
affects
affects
Yt output
output for
for
many
many
periods.
periods.
Because
Because
t inflation
inflation
expect-
expect-
ations
ations
adjust
adjust
slowly,
slowly,
actual
actual
inflation
inflation
t remains
remains
high
high for
for
many
many
periods.
periods.
t
The
The real
real
interest
interest
rate
rate takes
takes
many
many
rt periods
periods toto
return
return to
to
its
its natural
natural
rate.
rate.
The
The
t behavior
behavior
of
of the
the
nominal
nominal
interest
interest
rate
rate
depends
depends
on
on that
that
of
of the
the
it inflation
inflation
and
and real
real
interest
interest
rates.
rates.
A shock to aggregate demand
DASt +5
Y
Period
Periods
Period
Period
Periods
Period
Periods
Period
Periods
Period ttttt+ t+
t+ :t–t–++
:t+
15+5116::6::2:2
1+
π DASt +4 Positive
initial is4eq’m
and
DASPositive
initial
and
DAS
Higher
to
Higher
to higher:
tt +
+ is 4eq’m
higher: :: at
higher
higher
inflation
inflation at A Ain
in
DASt +3 demand
DAS
ttduedemand
DAS
due
Higher
raised to
togradually
higher
gradually
higher
inflation
inflation shock
shock
F Higher
raised inflation
G DASt +2 ((εε previous
shifts
shifts>> 0)
inflation
inflation
in
expectations 0)down
down shifts
inin as
shifts as
πt + 5 E in previous
expectations
for AD
inflation
preceding
AD
inflation
preceding
period to
tt ++
period to11the the and
,raisesand right;
period,
right;
period,
D DASt + 1 for ,raises
output
inflation
butoutputdemand
inflation
but demand
inflation
shifting
inflation and
and up.
DAS
C shifting DAS up.
DASt -1,t inflation
expectations
shock
inflation ends rise.
rise. and fall,
πt Inflation rises fall,
expectations
shock
expectations,
Inflation
expectations, ends rises and
B DAD
DAD
shifts
more,shifts returns
returns
DAS
output
DAS up.up.to
to
falls.
more, output falls.
economy
its
its initial
initial position.
economy
Inflation
Inflation position.
rises,
rises,
πt – 1 A DADt ,t+1,…,t+4 gradually
gradually
output
output falls. falls.
recovers
Eq’m
recovers
Eq’m at
at G. G. until
until
DADt -1, t+5 reaching
Y reaching
Yt + 5 Yt –1 Yt LR
LR eq’m eq’m at at A. A.

The dynamic response to a demand shock
The
The
demand
demand
t shock
shock
raises
raises
output
output for
for
five
five periods.
periods.
When
When thethe
shock
shock ends,
ends,
output
output falls
falls
below
below its
its
Yt natural
natural
level,
level, and
and
recovers
recovers
gradually.
gradually.
The
The
demand
demand
t shock
shock
causes
causes
inflation
inflation
to
to rise.
rise.
When
When the the
shock
shock ends,
ends,
inflation
inflation
t gradually
gradually
falls
falls toward
toward
its
its initial
initial
level.
level.
The
The
demand
demand
t shock
shock
raises
raises thethe
real
real interest
interest
rate.
rate.
After
After the
the
shock
shock ends,
ends,
the
the real
real
interest
interest
rt rate
rate falls
falls
and
and
approaches
approaches
its
its initial
initial
level.
level.
The
The
behavior
t behavior
of
of the
the
nominal
nominal
interest
interest
rate
rate
depends
depends
on
on that
that
of
of the
the
it inflation
inflation
and
and real
real
interest
interest
rates.
rates.
A shift in monetary policy
π Y Subsequent
Period
Period
Subsequent
Period
Period
Period
Period tt t–t–tt+:11:1:1 ::
:+
DASt -1, t periods:
target
periods:
Central
The
target
Central
The inflation
fall
inflation
fall inbank
bank
in ππtt
A DASt +1 This
rateThis
rate ππ**process
lowers
lowers
reduced
reduced process
== target
2%,
target
2%,
πt – 1 = 2% continues
continues
initial
initial
inflationeq’m
eq’m at atuntil
until
AA
B inflation
πt output
to ππ** ==returns
output
to
expectations returns
1%,
1%,
expectations
C to
to its
tt ++natural
its
raises natural
forraises
for 1,real
1, real
DASfinal rate
rate
interestand
and rate,
shifting
interest
shifting DAS
DASrate,
inflation
inflation
shifts
shifts DAD
downward.
downward. DAD
πfinal = 1% Z reaches
reaches
leftward.
Output
leftward.
Output rises,its
its new
rises, new
DADt – 1 target.
target.
Output
Output and
inflation falls.
and
inflation falls.
DADt, t + 1,… inflation
inflation fall. fall.
Y
Yt Yt –1 ,
CHAPTER 14 Dynamic AD-AS Y

Model
final
41
The dynamic response to a reduction in
target inflation
Reducing
Reducing
the
the target
 t* target
inflation
inflation
rate
rate
causes
causes
output
output to to
fall
fall below
below
its
its natural
natural
level
level for
for aa
Yt while.
while.
Output
Output
recovers
recovers
gradually.
gradually.
target inflation
 t*
Because
Because
expect-
expect-
ations
ations
adjust
adjust
slowly,
slowly,
itit takes
takes
many
many
t periods
periods for for
inflation
inflation to to
reach
reach the the
new
new target.
target.
target inflation
To
To reduce
reduce
inflation,
inflation,
 t* the
the central
central
bank
bank raises
raises
the
the real
real
interest
interest rate
rate
to
to reduce
reduce
aggregate
aggregate
demand.
demand.
The
The real
real
rt interest
interest rate
rate
gradually
gradually
returns
returns to to its
its
natural
natural rate.
rate.
target inflation
The
The initial
initial
increase
increase in in
the
the real
real
 t* interest
interest
rate
rate raises
raises
the
the nominal
nominal
interest
interest
rate.
rate.
As
As the
the
inflation
inflation
it and
and real
real
interest
interest
rates
rates fall,
fall,
the
the nominal
nominal
rate
rate falls.
falls.
APPLICATION:
Output variability vs. inflation variability
 A supply shock reduces output (bad)
and raises inflation (also bad).
 The central bank faces a tradeoff between these
“bads” – it can reduce the effect on output,
but only by tolerating an increase in the effect
on inflation….

APPLICATION:
CASE 1: θπ is large, θY is small
π A
A supply
supply shock
shock
In
In this
this case,
case, aa
shifts
shifts DAS
DAS up.
up.
small
small change
change in in
DASt inflation
inflation has
has aa
large
large effect
effect on
on
DASt – 1 output,
output, soso DAD
DAD
πt
is
is relatively
relatively flat.
flat.
πt –1
The
The shock
shock has
has
DADt – 1, t
aa large
large effect
effect
Y on
on output,
output, but
but
Yt Yt –1
aa small
small effect
effect
on
on inflation.
inflation.
APPLICATION:
CASE 2: θπ is small, θY is large
π In
In this
this case,
case, aa
large
large change
change inin
DASt inflation
inflation has
has only
only
πt aa small
small effect
effect on
on
DASt – 1 output,
output, soso DAD
DAD
is
is relatively
relatively steep.
steep.
πt –1
Now,
Now, the
the shock
shock
DADt – 1, t has
has only
only aa small
small
Y effect
effect on
on output,
output,
Yt Yt –1 but
but aa big
big effect
effect
on
on inflation.
inflation.
APPLICATION:
The Taylor Principle
 The Taylor Principle (named after John Taylor):
The proposition that a central bank should
respond to an increase in inflation with an even
greater increase in the nominal interest rate
(so that the real interest rate rises).
I.e., central bank should set θπ > 0.
 Otherwise, DAD will slope upward, economy may

be unstable, and inflation may spiral out of control.

APPLICATION:
 1
Yt  Yt  ( t   t ) 
*
t (DAD)
1  Y 1  Y
it   t     ( t   t* )  Y (Yt  Yt ) (MP rule)
If θπ > 0:
 When inflation rises, the central bank increases the
nominal interest rate even more, which increases the
real interest rate and reduces the demand for goods
& services.
 DAD has a negative slope.
APPLICATION:
 1
Yt  Yt  ( t   t ) 
*
t (DAD)
1  Y 1  Y
it   t     ( t   t* )  Y (Yt  Yt ) (MP rule)
If θπ < 0:
 When inflation rises, the central bank increases
the nominal interest rate by a smaller amount.
The real interest rate falls, which increases the
demand for goods & services.
 DAD has a positive slope.
APPLICATION:
 If DAD is upward-sloping and steeper than DAS,
then the economy is unstable: output will not return
to its natural level, and inflation will spiral upward
(for positive demand shocks) or downward
(for negative ones).
 Estimates of θπ from published research:
 θπ = –0.14 from 1960-78, before Paul Volcker
became Fed chairman. Inflation was high during
this time, especially during the 1970s.
 θπ = 0.72 during the Volcker and Greenspan years.
Inflation was much lower during these years.
Chapter Summary
 The DAD-DAS model combines five
relationships: an IS-curve-like equation of the
goods market, the Fisher equation, a Phillips
curve equation, an equation for expected
inflation, and a monetary policy rule.
 The long-run equilibrium of the model is
classical. Output and the real interest rate are
at their natural levels, independent of monetary
policy. The central bank’s inflation target
determines inflation, expected inflation, and the
nominal interest rate.
Chapter Summary
 The DAD-DAS model can be used to
determine the immediate impact of any shock
on the economy, and can be used to trace out
the effects of the shock over time.
 The parameters of the monetary policy rule
influence the slope of the DAS curve, so they
determine whether a supply shock has a
greater effect on output or inflation. Thus, the
central bank faces a tradeoff between output
variability and inflation variability.
Chapter Summary
 The DAD-DAS model assumes that the Taylor
Principle holds, i.e. that the central bank
responds to an increase in inflation by raising
the real interest rate. Otherwise, the economy
may become unstable and inflation may spiral
out of control.

N. Gregory Mankiw

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SEVENTH EDITION

© 2010 Worth Publishers, all rights reserved

CHAPTER 14 Dynamic AD-AS Model 3

CHAPTER 14 Dynamic AD-AS Model 4

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output natural real

CHAPTER 14 Dynamic AD-AS Model 8

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 t 1  increase in price level from period t to t +1,

Et  t 1  not known in period t

current previously supply

CHAPTER 14 Dynamic AD-AS Model 11

CHAPTER 14 Dynamic AD-AS Model 12

CHAPTER 14 Dynamic AD-AS Model 13

measures how much measures how much the

CHAPTER 14 Dynamic AD-AS Model 14

rt  Real interest rate

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CHAPTER 14 Dynamic AD-AS Model 21

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CHAPTER 14 Dynamic AD-AS Model 23

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CHAPTER 14 Dynamic AD-AS Model 26

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CHAPTER 14 Dynamic AD-AS Model 30

CHAPTER 14 Dynamic AD-AS Model 36

CHAPTER 14 Dynamic AD-AS Y

CHAPTER 14 Dynamic AD-AS Model 46

 Otherwise, DAD will slope upward, economy may

CHAPTER 14 Dynamic AD-AS Model 49

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