Unit - II NEW CLASSICAL ECONOMICS AND RATIONAL EXPECTATIONS.pptx

Assumption of Rational Expectation, Policy ineffectiveness, etc

1. Unit - II NEW CLASSICAL ECONOMICS AND RATIONAL EXPECTATIONS

2. NEW CLASSICAL ECONOMICS AND RATIONAL EXPECTATIONS Much of the difficulty policy makers encountered during the decade of the 1970s resulted from shifts in aggregate supply. Keynesian economics and, to a lesser degree, monetarism had focused on aggregate demand. These economists rejected the entire framework of conventional macroeconomic analysis. Indeed, they rejected the very term. For them there is no macroeconomics, nor is there something called microeconomics. For them, there is only economics, which they regard as the analysis of behaviour based on individual maximization. The analysis of the determination of the price level and real GDP becomes an application of basic economic theory, not a separate body of thought.

3. New Classical Economics: Like classical economic thought, new classical economics focuses on the determination of long-run aggregate supply and the economy’s ability to reach this level of output quickly. But the similarity ends there. Classical economics emerged in large part before economists had developed sophisticated mathematical models of maximizing behaviour. the new classical approach suggests that the economy will remain at or near its potential output, it follows that the changes we observe in economic activity result not from changes in aggregate demand but from changes in long-run aggregate supply. New classical economics suggests that economic changes don’t necessarily imply economic problems. New classical economists pointed to the supply-side shocks of the 1970s, both from changes in oil prices and changes in expectations, as evidence that their emphasis on aggregate supply was on the mark. They argued that the large observed swings in real GDP reflected underlying changes in the economy’s potential output.

4. Rational Expectations: Two particularly controversial propositions of new classical theory relate to the impacts of monetary and of fiscal policy. Both are implications of the rational expectations hypothesis, which assumes that individuals form expectations about the future based on the information available to them, and that they act on those expectations.  The rational expectations hypothesis suggests that monetary policy, even though it will affect the aggregate demand curve, might have no effect on real GDP. This possibility, which was suggested by Robert Lucas, is illustrated in the below Figure “ Contractionary Monetary Policy: With and Without Rational Expectations.” Suppose the economy is initially in equilibrium at point 1 in Panel (a). Real GDP equals its potential output, YP. Now suppose a reduction in the money supply causes aggregate demand to fall to AD2. In our model, the solution moves to point 2; the price level falls to P2, and real GDP falls to Y2. There is a recessionary gap. In the long run, the short-run aggregate supply curve shifts to SRAS2, the price level falls to P3, and the economy returns to its potential output at point 3

5. In the above Figure. Contractionary Monetary Policy: With and Without Rational Expectations. Panels (a) and (b) show an economy operating at potential output (1); a contractionary monetary policy shifts aggregate demand to AD2. Panel (a) shows the kind of response we have studied up to this point; real GDP falls to Y2 in period (2); the recessionary gap is closed in the long run by falling nominal wages that cause an increase in short-run aggregate supply in period (3). Panel (b) shows the rational expectations argument. People anticipate the impact of the contractionary policy when it is undertaken, so that the short-run aggregate supply curve shifts to the right at the same time the aggregate demand curve shifts to the left. The result is a reduction in the price level but no change in real GDP; the solution moves from (1) to (2).

6. The new classical story is quite different. Consumers and firms observe that the money supply has fallen and anticipate the eventual reduction in the price level to P3. They adjust their expectations accordingly. Workers agree to lower nominal wages, and the short-run aggregate supply curve shifts to SRAS2. This occurs as aggregate demand falls. As suggested in Panel (b), the price level falls to P3, and output remains at potential. The solution moves from (1) to (2) with no loss in real GDP. In this new classical world, there is only one way for a change in the money supply to affect output, and that is for the change to take people by surprise. An unexpected change cannot affect expectations, so the short-run aggregate supply curve does not shift in the short run, and events play out as in Panel (a). Monetary policy can affect output, but only if it takes people by surprise.

7. The new classical school offers an even stronger case against the operation of fiscal policy. It argues that fiscal policy does not shift the aggregate demand curve at all! Consider, for example, an expansionary fiscal policy. Such a policy involves an increase in government purchases or transfer payments or a cut in taxes. Any of these policies will increase the deficit or reduce the surplus. New classical economists argue that households, when they observe the government carrying out a policy that increases the debt, will anticipate that they, or their children, or their children’s children, will end up paying more in taxes. And, according to the new classical story, these households will reduce their consumption as a result. This will, the new classical economists argue, cancel any tendency for the expansionary policy to affect aggregate demand.

8. Policy Ineffectiveness Theorem (Developed by: Thomas J. Sargent & Neil Wallace, 1975) Introduction The Policy Ineffectiveness Theorem (PIT) is a proposition in macroeconomics that argues anticipated (systematic) monetary policy has no real effect on output and employment in the presence of rational expectations. This result challenged traditional Keynesian views which suggested that active monetary policy can stabilize the economy.

9. Historical Context Pre-1970s Keynesian view : Policy (especially monetary and fiscal) could influence real output and employment in the short run. Milton Friedman's Monetarism : Introduced the idea of natural rate of unemployment and adaptive expectations. Sargent & Wallace (1975) : Advanced the theory using rational expectations , arguing that if agents anticipate policy correctly, systematic policy is neutral.

10. Core Assumptions The theorem relies on several key assumptions: Rational Expectations Economic agents form expectations about the future using all available information optimally. On average, their expectations are correct (i.e., no systematic errors). Flexible Prices and Wages Prices and wages adjust quickly to equilibrate supply and demand in all markets. Market Clearing The economy is always at full employment (natural level of output). Monetary Policy Rule Known to Agents The policy rule (like money supply growth) is fully known and anticipated.

11. Theoretical Framework Aggregate Supply (Lucas Supply Curve) Yt =Yˉ+α(Pt−Et[Pt]) Yt : actual output Yˉ: natural level of output Pt​: actual price level Et​[Pt​]: expected price level α>0: sensitivity of output to price surprises Aggregate Demand Mt−Pt=−β Yt Mt​: nominal money supply Pt​: price level β>0: responsiveness of money demand to output

12. The Theorem STATEMENT : If monetary policy is systematic and anticipated, then it has no effect on real variables such as output and employment. EXPLANATION : When the central bank increases the money supply in a predictable way, agents adjust their expectations accordingly. As a result, the price level rises in line with expectations.

13. Implications of the Theorem Neutrality of Money : In the presence of rational expectations, only unanticipated changes in money supply can affect output . Limits to Discretionary Policy : Discretionary policy becomes ineffective unless it is unexpected . Role of Rules : Supports rule-based monetary policy (e.g., Taylor Rule) over activist stabilization policies. Expectations Management : Effective policy must manage expectations rather than react to economic conditions.

14. Criticisms of the Theorem Sticky Prices and Wages : In the real world, prices and wages may be rigid, which contradicts the assumption of flexibility. Information Imperfection : Agents may not have perfect information to form rational expectations. Empirical Evidence : Real-world data shows that systematic policy can influence output (especially in the short run). Central Bank Credibility : Policy effectiveness may depend on how credible and transparent the central bank is.

15. Extensions and Related Concepts Time Inconsistency Problem ( Kydland and Prescott, 1977): Even if policy is ineffective when anticipated, policymakers may have incentives to deviate. New Keynesian Response : Incorporates rational expectations but also emphasizes price stickiness to restore some effectiveness to policy. Real Business Cycle Theory : Reinforces the idea that fluctuations are due to real shocks, not policy changes.

16. Initial Equilibrium (E₁): At price level P₁ and output level Y₁ , the economy is in equilibrium (intersection of AD₁ and AS₁). Policy Action: Suppose the government undertakes an anticipated expansionary policy (e.g., increasing the money supply). This shifts the AD curve to the right: AD₁ → AD₂ . Rational Expectations Response: Economic agents anticipate the policy's effects and adjust wages, prices, and contracts accordingly. Their rational expectations cause the short-run aggregate supply curve to shift leftward: AS₁ → AS₂ . New Equilibrium (E₂): At the new equilibrium, the price level increases from P₁ to P₂ , but real output (Y) remains at Y₁ .

17. Conclusion (Policy Ineffectiveness Proposition) Anticipated policy changes do not affect real variables like output (Y) in the short run. Instead, the only effect is on nominal variables —in this case, the price level increases . This supports the idea that systematic monetary policy is ineffective in changing output if people form rational expectations .

18. Aggregate Supply Hypothesis Introduction to Aggregate Supply (AS) Aggregate Supply (AS) is the total quantity of goods and services that producers in an economy are willing and able to supply at a given overall price level in a given period. The Aggregate Supply Hypothesis explores how the total output responds to changes in the price level and other macroeconomic variables.

19. Aggregate Supply Curve Aggregate Supply Curve: Short Run vs Long Run Short-Run Aggregate Supply (SRAS) Positively sloped. In the short run, nominal wages and some input prices are sticky (do not change immediately). Firms respond to higher prices with increased output due to temporarily higher profits.

20. Long-Run Aggregate Supply (LRAS) Vertical at potential (full-employment) output. In the long run, input prices and wages are fully flexible. Output is determined by factors of production (capital, labour, technology), not price level.

21. Determinants of Aggregate Supply Short-Run AS Determinants: Nominal wages and labour costs Prices of raw materials and inputs Productivity of labour Exchange rates (imported input prices) Business taxes and regulations Long-Run AS Determinants: Quantity and quality of labour Capital stock (machinery, infrastructure) Technological advancements Institutional framework (legal system, education) Natural resources

22. Shifts in Aggregate Supply Curve SRAS Curve Shifts: Rightward Shift (increase in AS): ↓ Input prices, ↑ productivity Leftward Shift (decrease in AS): ↑ Input prices, ↑ taxes, ↓ productivity LRAS Curve Shifts: Changes in long-run productive capacity, e.g.,: Rightward : Better technology, more labour/capital Leftward : Natural disasters, loss of capital stock

23. Aggregate Supply Curve – Shifts

24. Policy Implications of Aggregate Supply Hypothesis Supply-side policies aim to increase LRAS: tax cuts, deregulation, education reforms, infrastructure investment. AS analysis helps explain stagflation (high inflation + low output) when SRAS shifts left. Understanding AS is crucial for fiscal and monetary policy planning.

25. Policy Implications of the Neoclassical Approach Introduction to Neoclassical Economics Neoclassical economics emerged in the late 19th century and became dominant in the 20th century. It is built on the foundations of Rational behaviour of individuals Utility maximization by consumers Profit maximization by firms Marginal analysis (decision-making at the margin) Market equilibrium through supply and demand interaction

26. Core Assumptions of the Neoclassical Model Assumption Description Rational agents Individuals and firms make logical decisions based on available information Full employment Markets adjust quickly to ensure resources are fully utilized Perfect competition Large number of buyers and sellers, free entry and exit Flexible prices and wages Prices adjust to clear markets (no persistent shortages/surpluses) Diminishing returns Marginal productivity of factors declines as more units are employed Neutrality of money Money affects only prices in the long run, not real variables

27. Neoclassical Growth Models: A Brief Context The Solow-Swan growth model (1956), a hallmark of neoclassical economics, emphasizes: Capital accumulation Exogenous technological progress Diminishing returns to capital and labour Convergence hypothesis – poor countries grow faster if they have similar savings and technology This underpins many policy implications for long-term growth and stability.

28. 4. Major Policy Implications of the Neoclassical Approach A. Limited Role for Government in Markets Markets are efficient : The neoclassical model assumes markets allocate resources efficiently on their own. Minimal intervention : Government policies are only needed to correct specific market failures (e.g., externalities, public goods). Privatization and liberalization : Encouraged to enhance efficiency and productivity. It emphasizes the belief in the “invisible hand” of the market.

29. B. Focus on Supply-Side Policies Neoclassical economics stresses increasing potential output rather than boosting demand. Supply-side policies include: Reducing taxes (especially on capital and labor ) Deregulating labour and product markets Promoting technological innovation Encouraging savings and investment Example: Tax cuts are believed to incentivize work, saving, and investment.

30. C. Balanced Budgets and Fiscal Prudence Fiscal deficits are discouraged as they may crowd out private investment by raising interest rates. Government borrowing increases demand for funds, leading to “crowding out.” Prefer balanced budgets and debt sustainability in the long run. Exception: In short-term recessions, Keynesians would disagree.

31. D. Monetary Policy over Fiscal Policy In the long run, monetary policy is neutral (affects only inflation, not output). Monetary policy should focus on price stability . Central banks should follow rules-based policies , e.g., Taylor Rule or inflation targeting. Example: The Monetarist view (Friedman) aligns with this – focus on controlling money supply growth.

32. E. Trade and Globalization Emphasis on free trade and comparative advantage Reducing tariffs and non-tariff barriers leads to efficient resource allocation and gains from trade Encouragement of foreign direct investment (FDI) and capital flows Policy example: Structural Adjustment Programs (SAPs) by IMF/WB are neoclassically inspired.

33. F. Human Capital and Technological Progress Exogenous technological change is key to long-run growth. Policy should promote: Education and training Research and development (R&D) Innovation ecosystems Knowledge spillovers and skilled labor are considered growth-enhancing factors.

34. 5. Criticisms and Limitations of Policy Implications Criticism Explanation Unrealistic assumptions Full employment, perfect information, and rational agents may not exist in real-world economies Inequality Market outcomes can be efficient but not equitable – distributional concerns are ignored Ignoring demand-side Especially in recessions, ignoring aggregate demand can prolong unemployment Technology as exogenous Later models (e.g., endogenous growth theory) argue innovation is influenced by policy and incentives

35. 6. Relevance in Modern Policy Making Despite criticisms, many modern economic policies still reflect neoclassical roots: Market deregulation Central bank independence Fiscal responsibility rules Trade liberalization

36. Policy Implications of Real Business Cycle (RBC) Theory Introduction to RBC Theory Real Business Cycle (RBC) Theory emerged in the 1980s as an alternative to Keynesian and Monetarist views of business cycles. It is based on neoclassical microeconomic foundations with rational expectations and intertemporal optimization by households and firms.

37. 2. Core Assumptions of RBC Theory Assumption Description Rational agents Individuals and firms maximize utility/profit over time Perfect competition Markets for goods, labor, and capital are competitive Flexible prices and wages No rigidities or frictions; prices adjust instantly Technology shocks Main drivers of economic fluctuations Intertemporal substitution Households substitute labor and consumption over time based on productivity and preferences Market clearing No involuntary unemployment; all fluctuations are voluntary responses to shocks

38. 3. Sources of Business Cycles in RBC Theory Positive or negative productivity shocks (e.g., new inventions, supply chain disruptions) Resource availability changes (e.g., oil prices, climate conditions) Government policies that affect production incentives Business cycles are viewed as efficient responses to real changes—not as failures requiring correction.

39. 4. Implications for Economic Policy A. Limited Role of Stabilization Policy Fiscal and monetary policies are largely ineffective and unnecessary . Fluctuations are optimal reactions to real shocks—attempts to “stabilize” the economy are distortionary . RBC considers business cycles as natural , desirable , and self-correcting phenomena. B. Policy Should Focus on Long-Run Growth RBC theory shifts policy focus from managing short-term fluctuations to promoting: Technological advancement Capital accumulation Labour market flexibility Efficient taxation and regulation

40. C. Opposition to Demand Management Policy Tool RBC View Fiscal stimulus Crowds out private investment, delays recovery Government spending Seen as distortionary if not productivity-enhancing Deficit financing Raises interest rates; reduces future capital formation Monetary policy Only affects nominal variables; real variables driven by real shocks

41. D. Emphasis on Supply-Side Reforms Policies that enhance productivity and flexibility are supported: Investment in R&D and infrastructure Labour market reforms (reduce rigidity) Deregulation and tax incentives for businesses Education and skill-building for human capital

42. E. Importance of Policy Predictability Uncertainty about future government actions may reduce productivity. RBC suggests rules-based, transparent policy-making to reduce distortions in intertemporal decisions. It Consistent tax and spending rules foster efficient planning by households and firms.

43. 5. Role of Government in RBC Theory Function RBC Recommendation Provide legal framework Protect property rights, enforce contracts Encourage innovation Support for technology and R&D Maintain competition Prevent monopolies; support open markets Infrastructure Public investment that enhances private sector productivity

44. 6. Policy Lessons from RBC in Practice Policy Domain Implication Business cycle management Avoid countercyclical fiscal or monetary policies Education & Training Invest to improve long-term productivity Labour flexibility Reduce rigid labor laws that delay adjustment Investment climate Stable taxation and regulation to encourage private investment

45. 7. Criticisms of RBC Policy Implications Criticism Explanation Ignores unemployment Views all unemployment as voluntary or optimal No role for demand shocks Empirical evidence shows demand-side crises (e.g., 2008) Price and wage rigidity ignored Real-world frictions delay adjustment Policy realism Assumes perfect foresight and rationality which may not exist in practice

46. 8. Comparison: RBC vs Keynesian Policy Implications Feature RBC Theory Keynesian Theory Role of policy Minimal Active stabilization Cause of cycles Real shocks (technology) Demand shocks Prices/Wages Fully flexible Sticky Unemployment Voluntary Involuntary Fiscal policy Distortionary Effective in recession Monetary policy Neutral in real terms Can influence output

47. Stabilization Policy and Unemployment 1. Introduction Stabilization policy refers to government actions aimed at reducing fluctuations in output, employment, and inflation . It mainly involves: Fiscal policy (government spending and taxation) Monetary policy (control of money supply and interest rates) Unemployment is a key indicator of economic instability. Stabilization policies aim to reduce unemployment, especially cyclical unemployment caused by recessions.

48. 2. Types of Unemployment Type Description Frictional Short-term unemployment due to job transitions Structural Mismatch between skills and jobs due to technological changes Cyclical Caused by a fall in aggregate demand (recession-related) Seasonal Linked to seasonal variations in labor demand Voluntary People choose not to work at the prevailing wage

49. 3. Relationship Between Business Cycle and Unemployment During Recession : Output falls → Demand for labour falls → Unemployment rises During Boom : Output rises → More jobs created → Unemployment falls Use of the Phillips Curve : In the short run, shows an inverse relationship between inflation and unemployment.

50. 4. Tools of Stabilization Policy A. Fiscal Policy Expansionary Fiscal Policy (during recession): Increase in government spending Decrease in taxes Aim: Increase aggregate demand and reduce unemployment Contractionary Fiscal Policy (during inflation): Reduce spending or increase taxes to cool the economy Example: The New Deal during the Great Depression (1930s) is a classic use of fiscal stimulus. B. Monetary Policy Expansionary Monetary Policy : Lower interest rates Increase money supply Encourage borrowing and investment → Stimulate employment Contractionary Monetary Policy : Raise interest rates to control inflation but may increase unemployment Role of Central Banks : RBI in India, Federal Reserve in the U.S., ECB in Europe

51. 5. Theoretical Frameworks A. Keynesian View Aggregate demand determines output and employment. The government should intervene during downturns to increase demand. Unemployment is involuntary and caused by insufficient demand. It advocates active use of stabilization policies. B. Classical/Neoclassical View Markets are self-correcting in the long run. Unemployment results from wage rigidity or labour market distortions. Policy intervention can be harmful or inflationary. It opposes persistent government intervention.

52. C. Monetarist View (Milton Friedman) Unemployment has a natural rate (NAIRU – Non-Accelerating Inflation Rate of Unemployment). Stabilization policies are useful only in the short run. Long-run unemployment cannot be reduced by demand-side policies.   D. New Classical and Rational Expectations People anticipate policy moves; thus, anticipated policies are ineffective . Only an unanticipated policy may affect real variables temporarily. Emphasis on credibility and rule-based policies.

53. 6. Stabilization Policies in Practice Country Example USA (2008) Stimulus under Obama to fight Great Recession India (2020) Atmanirbhar Bharat stimulus to offset COVID-19 impact Germany Kurzarbeit program to subsidize worker hours during slowdown

54. 7. Limitations of Stabilization Policies Limitation Description Time lags Recognition lag, decision lag, implementation lag Crowding out Government borrowing raises interest rates, reducing private investment Inflationary pressures Excessive stimulus can cause demand-pull inflation Ricardian equivalence People may save tax cuts expecting future tax hikes Policy credibility Inconsistent or politically motivated policies lose effectiveness

55. Role of Money in Business Cycle Theory Money plays a central role in economic activity by serving as: A medium of exchange A store of value A unit of account In business cycle theory , the role of money is crucial to understanding fluctuations in output, employment, and inflation . Different schools of thought view the role of money in business cycles differently , from a passive to an active influencer.

56. What is a Business Cycle? A business cycle refers to the recurring fluctuations in economic activity over time. Four Phases: Expansion Peak Contraction (Recession) Trough These fluctuations affect variables such as: GDP Employment Inflation Investment

57. 3. Schools of Thought on the Role of Money in Business Cycles A. Classical and Neoclassical Views Money is neutral in the long run. Business cycles are caused by real factors (e.g., technology, productivity). Money affects nominal variables only, not real output or employment. No active role for monetary policy. Use the vertical long-run aggregate supply (LRAS) curve to show neutrality of money.

58. B. Monetarist View (Milton Friedman) Money is not neutral in the short run. Changes in the money supply are a primary source of business cycle fluctuations. “ Inflation is always and everywhere a monetary phenomenon .” Emphasizes control of money supply growth to stabilize the economy. Key Concepts: Quantity Theory of Money : MV=PY (M = money supply, V = velocity, P = price level, Y = output) Policy Suggestion : Steady and predictable growth in the money supply. Friedman’s studies showed that downturns often followed declines in money supply (e.g., Great Depression).

59. C. Keynesian View Money matters significantly in the short run. Business cycles are driven by changes in aggregate demand . Monetary policy affects investment via the interest rate channel : ↓ Money supply → ↑ Interest rates → ↓ Investment → ↓ Output & Employment Liquidity preference theory: Money demand depends on income and interest rate. It shows the IS-LM model to explain how changes in money supply shift the LM curve and influence output.

60. D. New Classical View (Rational Expectations School) Emphasizes expectations of economic agents. Only unanticipated changes in money can affect real variables. Anticipated monetary policy is ineffective due to rational adjustments by agents. Policy Ineffectiveness Proposition (Sargent & Wallace): Predictable monetary policy is neutral . E. Real Business Cycle (RBC) Theory Money is not a central driver of business cycles. Cycles are caused by real shocks (technology, productivity, resource supply). Money plays a passive role; only reflects changes in the real economy.

61. F. New Keynesian Economics Accepts rational expectations but incorporates price and wage stickiness . Money affects output and employment in the short run . Emphasizes the importance of central bank credibility and expectations . Inflation targeting and monetary rules (Taylor Rule) are important tools in managing business cycles.

62. 4. Channels Through Which Money Affects Business Cycles Channel Explanation Interest Rate Channel Changes in money supply affect interest rates → influence investment and consumption Credit Channel Monetary policy affects bank lending and credit creation Wealth Effect Changes in money supply affect asset prices, which affect consumption Exchange Rate Channel Changes in domestic money supply affect exchange rates and net exports

63. 5. Role of Central Banks and Monetary Policy Central banks (e.g., RBI , Federal Reserve ) use monetary policy tools to influence money supply: Repo rate , Reverse repo rate Open market operations Cash reserve ratio (CRR) Statutory liquidity ratio (SLR) Goals of monetary policy : Control inflation Stabilize output Ensure employment Maintain financial stability

64. 6. Historical Examples Event Role of Money Great Depression (1930s) Sharp fall in money supply worsened the downturn (Monetarist view) 1970s Stagflation Loose monetary policy led to inflation without reducing unemployment 2008 Global Financial Crisis Central banks used quantitative easing to inject money and stabilize output COVID-19 Pandemic (2020) Expansionary monetary policies used globally to support economies

65. 7. Empirical Evidence Positive correlation between money supply growth and inflation (long run) Short-run impact on output and employment depends on: Expectations Degree of price/wage rigidity Financial market transmission Empirical studies often support short-run non-neutrality of money but long-run neutrality.

66. 8. Policy Implications Implication Explanation Monetary policy effectiveness Important for managing demand-side shocks and reducing volatility Inflation targeting Anchoring expectations through credible monetary frameworks Rule-based policies Reduce uncertainty and maintain central bank credibility Coordination with fiscal policy Joint stabilization efforts enhance policy effectiveness

67. 9. Criticisms and Limitations Criticism Explanation Time lags Recognition and implementation delays can reduce effectiveness Liquidity trap In low interest environments, monetary policy may be ineffective (Keynesian insight) Over-reliance on central banks May shift focus away from structural reforms Asset bubbles Loose monetary policy can inflate risky assets (e.g., housing bubble 2007)

68. The role of money in business cycles varies across economic schools. In the short run , monetary changes influence output, employment, and inflation. In the long run , money may be neutral, affecting only nominal variables. Effective, credible, and timely monetary policy is crucial for economic stabilization and growth.

69. DAD–DAS Model (Dynamic Aggregate Demand – Dynamic Aggregate Supply) 1. Introduction The DAD–DAS model is a dynamic version of the AD–AS model used in modern macroeconomic analysis . It is especially useful to study: The short-run and long-run behaviour of output and inflation The impact of monetary and fiscal policies over time Inflation expectations and their role in macroeconomic adjustment It integrates Phillips Curve dynamics , expectation formation , and policy rules into macroeconomic analysis.

70. 2. Motivation for the DAD–DAS Model Traditional AD–AS model is static — it does not account for expectations or time path adjustments. The DAD–DAS model introduces: Forward-looking behaviour Adaptive expectations or rational expectations Time-dependent dynamics of inflation and output

71. 3. Structure of the DAD–DAS Model A. DAD (Dynamic Aggregate Demand) Curve Shows combinations of output (Y) and inflation (π) consistent with equilibrium in the goods and money markets , given policy rules (monetary or fiscal). Derived from: IS curve (goods market) LM curve or monetary policy rule (e.g., Taylor Rule) Phillips curve (inflation-output relationship) Slope: Downward sloping in π–Y space Higher inflation → higher nominal interest rates → ↓ Investment → ↓ Output

72. Shifts due to: Monetary policy shocks Fiscal policy changes External shocks (e.g., oil prices, exchange rates)

73. B. DAS (Dynamic Aggregate Supply) Curve Captures the short-run behavior of inflation , depending on output gap and expected inflation . Based on: Expectations-augmented Phillips Curve: πt = πt–1 + φ( Yt – Yt ) + υt

74. Symbol Meaning Πt Current period inflation (actual inflation in time tt) πt−1 Lagged inflation (used as expected inflation, i.e., πte\pi^e_t) — based on adaptive expectations Φ Sensitivity coefficient showing how responsive inflation is to the output gap Yt Actual output in period tt Y* Potential (natural) output — full employment level Υt Supply shock term (e.g., oil price shocks, wage push, etc.)

75. Slope: Upward sloping : Higher output leads to higher inflation Shifts due to: Changes in inflation expectations Supply shocks (e.g., oil, wages, taxation)

76. 4. Short-Run vs Long-Run Dynamics Term Characteristics Short Run DAD and DAS determine output and inflation jointly; expectations are not fully adjusted Long Run Inflation expectations are fulfilled; output returns to potential level Y∗Y^*Y∗ Over time, the economy moves along DAS as expectations adapt, and inflation stabilizes.

77. 5. Equilibrium in the DAD–DAS Model Short-run equilibrium : Intersection of DAD and DAS Long-run equilibrium : When output = potential output and inflation expectations are realized It Show π (Inflation) on vertical axis and Y (Output) on horizontal axis. DAD is downward sloping, DAS is upward sloping.

78. 6. Policy Analysis with DAD–DAS Model A. Monetary Policy Expansionary monetary policy : Increases money supply or reduces interest rate Shifts DAD to the right → ↑ output, ↑ inflation Contractionary policy : DAD shifts left → ↓ output, ↓ inflation

79. B. Fiscal Policy Expansionary fiscal policy (↑ G or ↓ T): Increases output and inflation in the short run DAD shifts right Fiscal and monetary policies can stabilize output but may create inflation pressure if overused.

80. C. Supply Shocks Adverse supply shock (e.g., oil price rise): Shifts DAS upward → ↑ inflation, ↓ output Creates stagflation Favorable supply shock (e.g., productivity growth): Shifts DAS downward → ↓ inflation, ↑ output

81. Thank You