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 a major remaining difference is the treatment of inflation expectations. Textbook treatments typically assume adaptive expectations for tractability. In this paper, we extend the model presented in Mankiw [1] by incorporating a more flexible form of expectation formation that is 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 Taylorrule, 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. These features allow for the analysis of 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.
Highlights
For many decades, the teaching of business cycles has been dominated by the investment savings—liquidity money (IS-LM) model whereby monetary policy is summarized using an exogenous level of the money supply (Hicks [2]
These features allow for the analysis of the recent financial crisis, monetary policy falling into a liquidity trap, and the desirability of a temporary increase in the inflation target
These developments have brought the undergraduate treatment of business cycle fluctuations much closer to the research frontier where monetary policy is modeled as an interest rate rule and the analysis is undertaken in
Summary
The teaching of business cycles has been dominated by the investment savings—liquidity money (IS-LM) model whereby monetary policy is summarized using an exogenous level of the money supply (Hicks [2]). Inflationary expectations are typically assumed to be determined with adaptive expectations (Jones [4]; Mankiw [1]; Carlin and Soskice [7]; Kapinos [8]; Weisse [11]) This has important implications in terms of generating high inflation persistence with temporary shocks and imposing high output costs to disinflationary programs. When faced with a large increase in the risk-premium (or a large decline in demand), the Central Bank becomes unable to fully offset this shock due to the zero-bound We illustrate this liquidity trap situation, faced by the Federal Reserve during the recent financial crisis, using simulations from our model.
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