Monetary Theory:Monetary Theory:

ECO 285 – Macroeconomics – Dr. D. Foster

The AD/AS ModelThe AD/AS Model

Warning .. Warning .. WarningWarning .. Warning .. Warning

• Aggregate Supply and Aggregate Demand are not Aggregate Supply and Aggregate Demand are not like market supply & demand !!!!!like market supply & demand !!!!!

• The “static” analysis only hints at dynamic The “static” analysis only hints at dynamic interpretation.interpretation.

• Ceteris Paribus assumption problematic to the point Ceteris Paribus assumption problematic to the point of being wholly inappropriate.of being wholly inappropriate.

Contrasting views:Classical/Monetarist vs.

KeynesianFriedman vs. Keynes

Non-activist vs. Activist

The Aggregate Demand ScheduleThe Aggregate Demand Schedule

AD1

P

Q or R-GDP

BP1

Q2

AP2

Q1

P = Price Level;CPI or GDP deflator

Q = Y = Real GDP; (real output)

AD = Agg. Demand;From 4 sectors – HH, Bus, G, Foreign

Aggregate DemandAggregate Demand

• The price level and real output demanded are The price level and real output demanded are inversely related.inversely related.

• A fall in the price level will increase quantity A fall in the price level will increase quantity demanded.demanded.

• Why? -- the Why? -- the Real Balances EffectReal Balances Effect

• All prices and wages change.All prices and wages change.

• But, our fixed money holdings are … well, still fixed!But, our fixed money holdings are … well, still fixed!

• So, with lower prices we feel wealthier. Woo Hoo!So, with lower prices we feel wealthier. Woo Hoo!

• And, so we want to buy more stuff.And, so we want to buy more stuff.

Aggregate DemandAggregate Demand

• What about:What about:

Interest effectInterest effect Foreign trade effectForeign trade effect Exchange rate effectExchange rate effect

• AD can shift to the left or right.AD can shift to the left or right.

Increase AD – shift to the right.Increase AD – shift to the right.

Decrease AD – shift to the left.Decrease AD – shift to the left.

Whenever C, I, G, net X increase/decrease.Whenever C, I, G, net X increase/decrease.

Why? Due to changes in the money supply!Why? Due to changes in the money supply!

Can’t do “all else equal.”Can’t do “all else equal.” e.g. e.g. Price of apples - Price of apples - QQDD for apples ... for apples ...

and the and the QQDD for oranges. for oranges.

But, But, Price of everything and their isn’t Price of everything and their isn’t anything else to hold constant! anything else to hold constant!

The Aggregate Demand ScheduleThe Aggregate Demand Schedule

AD2

AD1

P

Q or R-GDP

AD3

Increases inC, I, G, net

X

Decreases in

C, I, G, net X

Money and Aggregate DemandMoney and Aggregate Demand

• Equation of exchangeEquation of exchange: An accounting identity:

• Quantity theory of moneyQuantity theory of money:People hold money for transactions purposes.Velocity (V) is constant, or, at least, stable (=1/k).Real output (Y) is constant w.r.t. labor supply.

Therefore, changes in MS will only change P.

• Aggregate Demand for output (AD) - derived from the demand for money, or - derived from the real balance effect.

MS * V = P * Y

MD = k * P * Y

AD2 MS/(k*P)

AD1

P

Q or R-GDP

AD3 MS/(k*P)

Increases in MS

Decreases

in MS

MD = MS

MS = k * P * Y

MS/(k * P) = Y

AD = MS/(k *

P)

QTM & The Aggregate Demand ScheduleQTM & The Aggregate Demand Schedule

The Money Supply and the Long Run Equilibrium The Money Supply and the Long Run Equilibrium between Aggregate Demand and Aggregate Supplybetween Aggregate Demand and Aggregate Supply

It is unaffected by changes in the price level, but is

affected by a host of real variables…

AD1

P

Q or R-GDP

ASLR

P1

Classical Model of the Economy

There is a “long run” Aggregate Supply,which is perfectly

verticalat the “full

employment”level of Real GDP.

The Money Supply and the Long Run Equilibrium The Money Supply and the Long Run Equilibrium between Aggregate Demand and Aggregate Supplybetween Aggregate Demand and Aggregate Supply

MS and that increases AD. MS and that

decreases AD.

AD1

P

Q or R-GDP

AS1

P1

Shifts in AD can only change the price level

and not real output (nor employment).

““Inflation is always, Inflation is always, and everywhere, a and everywhere, a

monetary monetary phenomenon.”phenomenon.”

-Milton Friedman

What affects the Aggregate Supply?What affects the Aggregate Supply?

• Labor force participation.

• Labor productivity.

• Marginal tax rates on wages.

• Provision of government benefits that affect household incentives w.r.t. supply labor.

• State of technology.

• Capital stock.A change in these

factors can AS (shift right)

or AS (shift left)

Short Run Aggregate Supply – Wage InflexibilityShort Run Aggregate Supply – Wage Inflexibility

• Nominal wages are sluggishsluggish upwards:A rise in prices has delayed effect on wages.

• Nominal wages are inflexibleinflexible downwards:A fall in prices will result in employment and y.

• Workers have money illusionmoney illusion:Higher nominal wages are viewed as real wage.So, more workers available even though real wage

has not risen. e.g. if prices rise 5% and wages rise 3%…e.g. if prices rise 5% and wages rise 3%…

Short Run Aggregate SupplyShort Run Aggregate Supply

• The Short Run will adjust to the Long RunThe Short Run will adjust to the Long Run: An AD will P and Q, but only in the SR.

Prices rise but wages lag. Firms employment and output.

Eventually, workers realize their real wages (W/P) are falling, get comparable wage, AS. The temporary profit motive has been eliminated.

• What about:What about:

Sticky pricesSticky prices MisperceptionMisperception Intertemporal substitutionIntertemporal substitution

Unnecessary complicationsUnnecessary complicationsto explain the SR AS.to explain the SR AS.

Inflexible wages is all we need.Inflexible wages is all we need.

What happens if there is a AD?

From SR to LR Aggregate SupplyFrom SR to LR Aggregate Supply

An increase An increase in AD triggers in AD triggers

events.events.

Prices rise,Prices rise,wages lag,wages lag,

output output risesrises..

Eventually,Eventually,wages catch upwages catch up

and AS declines.and AS declines.

In LR, In LR, onlyonlyprices riseprices rise..AD

1

P

Q or R-GDP

ASLR

P1

AS1

AD2

P2

Q2Q*

P3

AS2

AS3

AS/AD Model – Hints at 4 types of changesAS/AD Model – Hints at 4 types of changes

• Inflation with growth due Inflation with growth due to rising AD.to rising AD.

• Depression with deflation Depression with deflation due to falling AD.due to falling AD.

• Growth with deflation due Growth with deflation due to rising AS.to rising AS.

• Depression with inflation Depression with inflation due to falling AS. due to falling AS. (stagflation)(stagflation)

AD1

P

Q or R-GDP

ASLR

P1

AS1

Q*

Are Monetary Policies Effective?Are Monetary Policies Effective?

• In the Short Run: If they are unexpected. If wage/price rigidities persist.

Over time, these should be less likely.

• How are expectations formed?Adaptively.Rationally.

Velocity of M1, M2 and MZM, 1960-2013Velocity of M1, M2 and MZM, 1960-2013

Persistent inflation & inflationary expectationsPersistent inflation & inflationary expectations

The Fed tries to reduce The Fed tries to reduce unemployment and unemployment and increase output by increase output by MS. This MS. This AD.AD.

AD1

P

Q or R-GDP

P1

AS1

AD2

Q*

P3

AS2AS3

AD2

AS4

P2

AS5

P4 With a lag, the AS will decrease so all we see is P.

The Fed keeps trying, The Fed keeps trying, but now no lag in but now no lag in AS.AS.

If the Fed stops If the Fed stops inflationary inflationary expectations expectations will continue to will continue to AS, now AS, now Q.Q.

Monetarist vs. KeynesianMonetarist vs. Keynesian

How fast can the economy recover from recession? very fast not very fast G source of disruption Mkt. source of disruption

What are the initial causes of a recession? MS Investment Fed as source Lack of “animal spirits”

Should the gov’t aid in the recover from recession? No, use rule Yes, use discretion Favor monetary policy Favor fiscal policy

What is the effect of raising G and raising T? G dubious effects G is the key to success T slows economic growth T is easily offset by G

Monetarist vs. Keynesian Short Run Aggregate SupplyMonetarist vs. Keynesian Short Run Aggregate Supply

The AS is flat in The AS is flat in the the KeynesianKeynesian view and steep view and steep according to the according to the

MonetaristsMonetarists..

So, a decrease in So, a decrease in the AD will have the AD will have

different different consequences in consequences in the two theories.the two theories.

AD1

P

Q or R-GDP

ASLR

P1

AS - Keynes

Q*

AS - Monetarist

AD2

Other observations on the Business CycleOther observations on the Business Cycle

Can we eliminate inflation by Can we eliminate inflation by AS (short run)?AS (short run)?

No, these policies are “doomed to failure.”

Remember, inflation is a monetary phenomenon,

and caused by shifts in the AD.

So, what are these policies?

• Wage & price controlsWage & price controls

• Tax-based Incomes policies (TIPs)Tax-based Incomes policies (TIPs)

• Supply-side incentives to boost output.Supply-side incentives to boost output.

• Remove barriers that keep wages/prices from falling.Remove barriers that keep wages/prices from falling.

Other observations on the Business CycleOther observations on the Business Cycle

To eliminate inflation we must To eliminate inflation we must AD.AD.

But, we’ll have to contend with inflationary expectations.

How?

• Gradualism approachGradualism approach

• Going cold turkeyGoing cold turkey

• IndexingIndexing

• Wages, mortgage interest rates, taxes …Wages, mortgage interest rates, taxes …

And, what of the role of government?And, what of the role of government?

Increasing share of GDP & growth is slower, recoveries taking longer. Benefits of G may not be worth the costs.

Current Problems & Policy QuestionsCurrent Problems & Policy Questions

AD

Q = Real GDP

P1

Prices

Q*

ASLR

ASSR

AD’

Q’

P2

•Decreased AD Decreased AD sends us into sends us into recession.recession.

AD’’

P3

AD’’’

•Fed expands the MS Fed expands the MS to stimulate economic to stimulate economic growth. Doesn’t work.growth. Doesn’t work.

•Eventually, there’s Eventually, there’s an overreaction.an overreaction.

•Sharply rising AD Sharply rising AD leads to high levels of leads to high levels of inflation.inflation.

What will be the effect of the

Fed’s having MB to $4 tr and TR

to $2.6 tr?

Monetary Theory:Monetary Theory:

ECO 285 – Macroeconomics – Dr. D. Foster

The AD/AS ModelThe AD/AS Model