Macroeconomics

F I G U R E

1 4 - 3

Inflation, 

p

p

Income, output, Y

Dynamic aggregate

demand, DAD

t

The Dynamic Aggregate Demand

Curve

The dynamic aggregate

demand curve shows a negative associ-

ation between output and inflation. Its

downward slope reflects monetary pol-

icy and the demand for goods and ser-

vices: a high level of inflation causes

the central bank to raise nominal and

real interest rates, which in turn

reduces the demand for goods and

services. The dynamic aggregate

demand curve is drawn for given val-

ues of the natural level of output Y

−

t

,

the inflation target 

p

t

*, and the

demand shock 

e

t

. When these exoge-

nous variables change, the curve shifts.

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P A R T   I V

Business Cycle Theory: The Economy in the Short Run

The Short-Run Equilibrium

The economy’s short-run equilibrium is determined by the intersection of the

dynamic aggregate demand curve and the dynamic aggregate supply curve.

The economy can be represented algebraically using the two equations we

have just derived:

Y

t

= Y−

t

– [

av

p

/(1 

+

av

Y

)](

p

t

−

p

t

*) 

+ [1/(1 +

av

Y

)]

e

t

.

(DAD)

p

t

=

p

t

−1

+

f

(Y

t

− Y−

t

) 

+

u

t

.

(DAS)

In any period t, these equations together determine two endogenous variables:

inflation 

p

t

and output Y

t

. The solution depends on five other variables that are

exogenous (or at least determined prior to period t). These exogenous (and pre-

determined) variables are the natural level of output Y

−

t

, the central bank’s target

inflation rate 

p

t

*, the shock to demand 

e

t

, the shock to supply 

u

t

, and the previ-

ous period’s rate of inflation 

p

t

−1

.

Taking these exogenous variables as given, we can illustrate the economy’s

short-run equilibrium as the intersection of the dynamic aggregate demand

curve and the dynamic aggregate supply curve, as in Figure 14-4. The short-run

equilibrium level of output Y

t

can be less than its natural level Y

−

t

, as it is in this

figure, greater than its natural level, or equal to it. As we have seen, when the

economy is in long-run equilibrium, output is at its natural level (Y

t

= Y−

t

).

The short-run equilibrium determines not only the level of output Y

t

but also

the inflation rate 

p

t

. In the subsequent period (t

+ 1), this inflation rate will

become the lagged inflation rate that influences the position of the dynamic

aggregate supply curve. This connection between periods generates the dynamic

patterns that we will examine below. That is, one period of time is linked to the

next through expectations about inflation. A shock in period t affects inflation in

period t, which in turn affects the inflation that people expect for period t

+ 1.

Expected inflation in period t

+ 1 in turn affects the position of the dynamic