Question

Hi. i need answer for this question as quickly as possible.

Consider the AS-AD model:

Y˜ t = α − βµ(πt − π¯),

where Y˜ t is short-run output, πt is current inflation and ¯π is an inflation target pursued by the central bank. The AS curve can be written:

πt = πt−1 + νY˜ t + σ.

a. Explain where the two equations come from and explain the intuition behind them.

b. How would you interpret α and σ? Which values must they assume in a steady-state, i.e. in the long run.

c. Analyse the effect of making the inflation target more ambitious, i.

e. the effect of lowering π¯. Illustrate your answer in a diagram and explain the intuition. d. Suppose that the demand for domestic goods increases abroad, so that the export share of potential output temporarily increases. Analyse the effects on inflation and short-run output using a diagram.

Answer 1

a)

The current AD-AS relation is derived from combining Phillips equation and Okun's law. The intuition behind them is that higher inflation leads to higher employment of laborers and hence higher wages. This leads to further inflation. Therefore, central banks target inflation at a specific level and adjust the output accordingly to maintain stability in an economy.

b)

can be interpreted as a natural rate of output, such that when inflation is at the target level the output is at the long term level. Similarly, can be interpreted as a long term constant that tends to fall as inflation in the current period approaches to last year's level.