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

30 Pages Posted: 21 Aug 2011

See all articles by Sami Alpanda

Sami Alpanda

University of Central Florida

Adam Honig

Amherst College - Department of Economics

Geoffrey R. Woglom

Amherst College - Department of Economics

Date Written: July 1, 2011

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 one major difference is the treatment of inflation expectations. Textbook treatments typically assume adaptive expectations for tractability. In this paper, we incorporate a more flexible form of expectation formation by allowing it to be 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. We use these features to motivate a discussion regarding 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: AD-AS, inflation expectations, optimal monetary policy, liquidity trap

JEL Classification: A22, E32

Suggested Citation

Alpanda, Sami and Honig, Adam and Woglom, Geoffrey R., 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 (July 1, 2011). Available at SSRN: https://ssrn.com/abstract=1913441 or http://dx.doi.org/10.2139/ssrn.1913441

Sami Alpanda (Contact Author)

University of Central Florida ( email )

4000 Central Florida Blvd
Orlando, FL 32816-1400
United States

Adam Honig

Amherst College - Department of Economics ( email )

P.O. Box 5000
Amherst, MA 01002-5000
United States
413-542-5032 (Phone)

Geoffrey R. Woglom

Amherst College - Department of Economics ( email )

P.O. Box 5000
Amherst, MA 01002-5000
United States
413-542-2433 (Phone)
413-256-8242 (Fax)

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