Monetary Theory:

1. Monetary Theory: The AD/AS Model ECO 285 – Macroeconomics – Dr. D. Foster

2. Warning .. Warning .. Warning • Aggregate Supply and Aggregate Demand are not like market supply & demand !!!!! • The “static” analysis only hints at dynamic interpretation. • Ceteris Paribus assumption problematic to the point of being wholly inappropriate. Contrasting views: Classical/Monetarist vs. Keynesian Friedman vs. Keynes Non-activist vs. Activist

3. The Aggregate Demand Schedule P P = Price Level; CPI or GDP deflator Q = Y = Real GDP; (real output) AD = Agg. Demand; From 4 sectors – HH, Bus, G, Foreign A P2 B P1 AD1 Q or R-GDP Q1 Q2

4. Aggregate Demand • The price level and real output demanded are inversely related. • A fall in the price level will increase quantity demanded. • Why? -- the Real Balances Effect • All prices and wages change. • But, our fixed money holdings are … well, still fixed! • So, with lower prices we feel wealthier. Woo Hoo! • And, so we want to buy more stuff.

5. Aggregate Demand Can’t do “all else equal.” e.g. Price of apples - QD for apples ... and the QDfor oranges. But, Price of everything and their isn’t anything else to hold constant! • What about: • Interest effect • Foreign trade effect • Exchange rate effect • AD can shift to the left or right. • Increase AD – shift to the right. • Decrease AD – shift to the left. • Whenever C, I, G, net X increase/decrease. • Why? Due to changes in the money supply!

6. AD2 The Aggregate Demand Schedule P Increases in C, I, G, net X AD3 Decreases in C, I, G, net X AD1 Q or R-GDP

7. Money and Aggregate Demand • Equation of exchange: • An accounting identity: MS * V = P * Y • Quantity 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. MD = k * P * Y

8. AD2MS/(k*P) QTM & The Aggregate Demand Schedule P MD = MS MS = k * P * Y MS/(k * P) = Y AD = MS/(k * P) Increases in MS AD3 MS/(k*P) Decreasesin MS AD1 Q or R-GDP

9. The Money Supply and the Long Run Equilibrium between Aggregate Demand and Aggregate Supply P There is a “long run” Aggregate Supply,which is perfectly verticalat the “full employment”level of Real GDP. ASLR It is unaffected by changes in the price level, but is affected by a host of real variables… P1 Classical Model of the Economy AD1 Q or R-GDP

10. The Money Supply and the Long Run Equilibrium between Aggregate Demand and Aggregate Supply P MS and that increases AD. MS and that decreases AD. AS1 Shifts in AD can only change the price level and not real output (nor employment). “Inflation is always, and everywhere, a monetary phenomenon.” -Milton Friedman P1 AD1 Q or R-GDP

11. 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)

12. Short Run Aggregate Supply – Wage Inflexibility • Nominal wages are sluggish upwards: • A rise in prices has delayed effect on wages. • Nominal wages are inflexible downwards: • A fall in prices will result in employment and y. • Workers have money 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%…

13. Short Run Aggregate Supply • The 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: • Sticky prices • Misperception • Intertemporal substitution Unnecessary complicationsto explain the SR AS.Inflexible wages is all we need. What happens if there is a AD?

14. From SR to LR Aggregate Supply An increase in AD triggers events. AS3 P ASLR AS2 AS1 Prices rise, wages lag, output rises. Eventually, wages catch up and AS declines. In LR, onlyprices rise. P3 P2 P1 AD2 AD1 Q or R-GDP Q2 Q*

15. AS/AD Model – Hints at 4 types of changes P ASLR • Inflation with growth due to rising AD. • Depression with deflation due to falling AD. • Growth with deflation due to rising AS. • Depression with inflation due to falling AS. (stagflation) AS1 P1 AD1 Q or R-GDP Q*

16. 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.

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

18. Persistent inflation & inflationary expectations AS5 The Fed tries to reduce unemployment and increase output by MS. This AD. AS4 AS3 P AS2 AS1 With a lag, the AS will decrease so all we see is P. P3 The Fed keeps trying, but now no lag in AS. If the Fed stops inflationary expectations will continue to AS, now Q. P1 P2 P4 AD2 AD2 AD1 Q or R-GDP Q*

19. Monetarist 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

20. Monetarist vs. Keynesian Short Run Aggregate Supply The AS is flat in the Keynesian view and steep according to the Monetarists. P ASLR AS - Monetarist AS - Keynes So, a decrease in the AD will have different consequences in the two theories. P1 AD1 AD2 Q or R-GDP Q*

21. Other observations on the Business Cycle • Can we eliminate inflation by 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 controls • Tax-based Incomes policies (TIPs) • Supply-side incentives to boost output. • Remove barriers that keep wages/prices from falling.

22. Other observations on the Business Cycle • To eliminate inflation we must AD. • But, we’ll have to contend with inflationary expectations. • How? • Gradualism approach • Going cold turkey • Indexing • Wages, mortgage interest rates, taxes … • 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.

23. Current Problems & Policy Questions • Decreased AD sends us into recession. Prices ASLR ASSR • Fed expands the MS to stimulate economic growth. Doesn’t work. P3 AD’’’ • Eventually, there’s an overreaction. P1 AD P2 • Sharply rising AD leads to high levels of inflation. AD’’ AD’ What will be the effect of the Fed’s having MB to $4 tr and TR to $2.6 tr? Q’ Q = Real GDP Q*

24. Monetary Theory: The AD/AS Model ECO 285 – Macroeconomics – Dr. D. Foster