The classical model of macroeconomics. The CLASSICAL model of macroeconomics is the polar opposite of the extreme Keynesian model. It analyses the economy when wages and prices are fully flexible. In this model, the economy is always at its potential level. - PowerPoint PPT Presentation
Welcome message from author
This document is posted to help you gain knowledge. Please leave a comment to let me know what you think about it! Share it to your friends and learn new things together.
• Previously it was assumed that prices were fixed and so we talked in terms of a simple Taylor Rule where interest rates responded to the output part of the rule.
• Here, we allow prices to vary and think in terms of the Taylor Rule where interest rates respond to both output and inflation.– In this case, higher inflation leads to the bank
raising the interest rate, thus reducing aggregate demand and output.
• The macroeconomic demand schedule (MDS) shows the combinations of inflation and output for which aggregate demand equals output when the interest rate is set by a Taylor Rule.
• Higher inflation is associated with lower aggregate demand and lower output.
• The slope of the schedule is determined by:– the reaction of interest rate decisions to inflation– and the responsiveness of aggregate demand to interest
rate changes
• Consequently:– It will be flat when
• interest rate decisions respond a lot to inflation• and aggregate demand is highly responsive to interest rate
changes.
– It will be steep when• interest rate decisions do not respond much to inflation• and aggregate demand responds little to interest rate
A beneficial supply shock raisespotential output by shifting AS0 to
AS1and lowers inflation to 2* at D.
D2*
Y1*
Equilibrium inflation: a supply shock
Output
Inflation
MDS0
0*
Y0*
A
AS0
If the central bank pursues itstarget of 0* when the economy
is at potential output, it mustrespond by reducing its targetreal interest rate.This will lead to an increasedamount of money being demanded:to achieve, money marketequilibrium at this interest rate,the bank must supply more money.
the inflation target is cutfrom * to 3*: the raising of
interest rates to achieve thisshifts MDS to MDS'.
Output
Inflation
Y*
SAS
*E
MDS
AS
A lower inflation targetStarting from long-runequilibrium at E:
E'1*Given wage levels, firms adjust to E' in the short run.With inflation at ' but wagesunchanged, the real wagerises bringing involuntary unemployment.
3
SAS3
E3
Equilibrium is eventually reached at E3, back at Y*.
SAS'
As the labour market (wage)adjusts SAS shifts e.g. toSAS’.
• One way round this is to to steer a middle course by using a Taylor Rule, i.e. a rule that takes into account deviations of both inflation and output from their long-run levels.
• Another is to allow flexible inflation targeting– because the inflation target is a medium-run
one, this allows some discretion for reducing variability in output