The full dynamic short-run model. The Dynamic Model. A nice new addition to Mankiw. Combines - IS - LM (changed to reflect central bank targeting) - Phillips curve Closed economy Short-run of business cycles Keynesian rather than classical. Monetary policy rule. Taylor rule:
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A nice new addition to Mankiw.
- LM (changed to reflect central bank targeting)
- Phillips curve
Short-run of business cycles
Keynesian rather than classical
i t = πt + θπ(πt - π*) +θY (Yt - Y* )
Rationale: a rule that incorporates both real and inflation targets
But, also one that has good stability properties
Derived from minimizing loss function such as
L = θπ(πt - π*) 2 +θY (lnYt - lnY* ) 2
[This version has loss function the same as the Taylor run. It seems more likely that the optimal Y* would be above potential output.]
Fedfunds* = pi +2 + .5*(pi – 2) - .25*(u – nairu)
pi = 4 quarter PCE core inflation
Why is rate below target today?
1. Demand for goods and services: Yt = Y* - α (rt –r*) + μG + εt
2. Cost of capital: rt = it – πe t + risk premium
3. Phillips curve: πt = πe t + φ(Yt - Y* ) + vt
4. Inflation expectations: πe t = π t-1
5. Monetary policy: i t = πt + θπ(πt - π*) +θY (Yt - Y* )
AD: Y t = -[α θπ /(1+ α θ Y )] πt + μ /(1+ α θ Y )]G +…
AS: πt = πt-1 + φ(Yt - Y* ) + vt
AD is like IS-LM equilibrium except is substitutes the Fed response for a fixed money supply
AS is Phillips curve with substituting for expected inflation
Note that we have moved up one derivative from intro AD-AD because of Phillips curve.
Y = real output (GDP)
Y = real output (GDP)
This will be available on course web page.
You might download and do some experiments to see how it works.
New kind of economics: computerized modeling.
[The screen shots are ones that were used in class. The model posted on the course web site is slightly changed from that version.]
This now finishes our treatment of closed-economy business cycles.
Key elements are
- IS elements in I, C, fiscal policy, and trade
- Financial markets and monetary policy
- Inflation dynamics
Can we abolish the business cycle?