Extending the Textbook Dynamic AD-AS Framework with Flexible Inflation Expectations, Optimal Policy Response to Demand Changes, and the Zero-Bound on the Nominal Interest Rate

Abstract

Many popular macroeconomics textbooks have recently adopted the dynamic aggregate demand – aggregate supply framework to analyze business cycle fluctuations and the effects of monetary policy. This brings the textbook treatment much closer to the research frontier, although one major difference is the treatment of inflation expectations. Textbook treatments typically assume adaptive expectations for tractability. In this paper, we incorporate a more flexible form of expectation formation by allowing it to be determined as a weighted average of past inflation and the inflation target. This brings the treatment closer to rational expectations and allows for a discussion of costless disinflation. Monetary policy is assumed to follow a Taylor rule, but we allow for deviations from the rule to motivate a discussion regarding optimal monetary policy response to demand shocks. We also include a shock to the risk-premium on the interest rate relevant for demand relative to the policy rate set by the Central Bank, and impose the zero bound on the nominal interest rate in the solution of the model. We use these features to motivate a discussion regarding the recent financial crisis, monetary policy falling into a liquidity trap, and the desirability of a temporary increase in the inflation target. Finally, we make available an Excel sheet with which students can analyze the effect of shocks to the economy using impulse responses and dynamic aggregate demand – aggregate supply diagrams.