A Dynamic Model of Economic Fluctuations

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The important thing in science is not so much to obtain new facts as to discover new ways of thinking about them.

—William Bragg

The opening quotation from William Bragg (a physicist who lived about a century ago) applies just as much to economics and other social sciences as it does to the natural sciences. Many of the facts that economists study are those that the media report every day—changes in national income, inflation, unemployment, the trade balance, and so on. Economists develop models to provide new ways to think about these familiar facts. A good model is one that not only fits the facts but also offers new insights into them.

In the previous chapters, we have examined models that explain the economy both in the long run and in the short run. It might seem that, in some sense, our study of macroeconomic theory is complete. But to believe so would be a mistake. Like all scientists, economists never rest. There are always more questions to be answered, more refinements to be made. In this chapter and the next two, we look at some advances in macroeconomic theory that expand and refine our understanding of the forces that govern the economy.

This chapter presents a model that we will call the dynamic model of aggregate demand and aggregate supply. This model offers another lens through which we can view short-run fluctuations in output and inflation and the effects of monetary and fiscal policy on those fluctuations. As the name suggests, this new model emphasizes the dynamic nature of economic fluctuations. The dictionary defines the word “dynamic” as “relating to energy or objects in motion, characterized by continuous change or activity.” This definition applies readily to economic activity. The economy is continually bombarded by various shocks. These shocks not only have an immediate impact on the economy’s short-run equilibrium but also affect the subsequent path of output, inflation, and many other variables. The dynamic AD–AS model focuses attention on how output and inflation respond over time to changes in the economic environment.

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In addition to placing greater emphasis on dynamics, the model differs from our previous models in another significant way: It explicitly incorporates the response of monetary policy to economic conditions. In previous chapters, we followed the conventional simplification that the central bank sets the money supply, which in turn is one determinant of the equilibrium interest rate. In the real world, however, many central banks set a target for the interest rate and allow the money supply to adjust to whatever level is necessary to achieve that target. Moreover, the target interest rate set by the central bank depends on economic conditions, including both inflation and output. The dynamic AD–AS model builds in these realistic features of monetary policy.

Although the dynamic AD–AS model is new to the reader, most of its components are not. Many of the building blocks of this model will be familiar from previous chapters, even though they sometimes take on slightly different forms. More important, these components are assembled in new ways. You can think of this model as a new recipe that mixes familiar ingredients to create a surprisingly original meal. In this case, we will mix familiar economic relationships in a new way to produce deeper insights into the nature of short-run economic fluctuations.

Compared to the models in preceding chapters, the dynamic AD–AS model is closer to those studied by economists at the research frontier. Moreover, economists involved in setting macroeconomic policy, including those working in central banks around the world, often use versions of this model when analyzing the impact of economic events on output and inflation.