Macroeconomics

F I G U R E

1 4 - 6

Inflation, 

p

p

p

t

p

t + 1

p

t – 1

Income, output, Y

A

C

B

DAS

t

DAD

all

DAS

t + 1

DAS

t – 1

Y

t

Y

t + 1

Y

t – 1

3. . . . and output to fall.

2. . . . causing

inflation to

rise . . .

Y

all

1. An adverse supply

shock shifts the DAS

curve upward, . . .

A Supply Shock

A supply

shock in period t shifts the

dynamic aggregate supply

curve upward from DAS

t

−1

to DAS

t

. The dynamic

aggregate demand curve is

unchanged. The economy’s

short-run equilibrium

moves from point A to

point B. Inflation rises and

output falls. In the subse-

quent period (t

+ 1), the

dynamic aggregate supply

curve shifts to DAS

t

+1

and

the economy moves to

point C. The supply shock

has returned to its normal

value of zero, but inflation

expectations remain high.

As a result, the economy

returns only gradually to its

initial equilibrium, point A.

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C H A P T E R   1 4

A Dynamic Model of Aggregate Demand and Aggregate Supply

| 425

curve shifts upward by exactly the size of the shock, which we assumed to be 1

percentage point. Because the supply shock 

u

t

is not a variable in the dynamic

aggregate demand equation, the DAD curve is unchanged. Therefore, the econ-

omy moves along the dynamic aggregate demand curve from point A to point

B. As the figure illustrates, the supply shock in period t causes inflation to rise to

p

t

and output to fall to Y

t

.

These effects work in part through the reaction of monetary policy to the

shock. When the supply shock causes inflation to rise, the central bank responds

by following its policy rule and raising nominal and real interest rates. The high-

er real interest rate reduces the quantity of goods and services demanded, which

depresses output below its natural level. (This series of events is represented by

the movement along the DAD curve from point A to point B.) The lower level

of output dampens the inflationary pressure to some degree, so inflation rises

somewhat less than the initial shock.

FYI

The text presents some numerical simulations of

the dynamic AD–AS model. When interpreting

these results, it is easiest to think of each period

as representing one year. We examine the impact

of the change in the year of the shock (period t)

and over the subsequent 12 years.

The simulations use these parameter values:

Y

−

t

= 100.

p

t

*

= 2.0.

a

= 1.0.

r

= 2.0.

f

= 0.25.

v

p = 0.5.

v

Y

= 0.5.

Here is how to interpret these numbers. The nat-

ural level of output Y

−

t

is 100; as a result of choos-

ing this convenient number, fluctuations in Y

t

− Y

−

t

can be viewed as percentage deviations of output

from its natural level. The central bank’s inflation

target 

p

t

* is 2 percent. The parameter 

a

= 1.0

implies that a 1-percentage-point increase in the

real interest rate reduces output demand by 1,

which is 1 percent of its natural level. The econo-