Monetary Theory: The AD/AS Model – Pt. II ECO 473 – Money & Banking – Dr. D. Foster

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

Aggregate Demand Aggregate Supply The price level and real output demanded are inversely related. A fall in the price level will increase quantity demanded. Aggregate Supply In the long run it is fixed at the level of the full employment of resources. A change in the price level will not affect AS-LR.

The Money Supply and the Long Run Equilibrium between Aggregate Demand and Aggregate Supply ASLR There is a “long run” Aggregate Supply, which is perfectly vertical at the “full employment” level of Real GDP. 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

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%…

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

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

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

The Transmission Mechanism of Monetary Policy Fed buys bonds. Bank reserves rise, as do their excess reserves. The money supply expands. Interest rates fall to equate MS with MD. Investment spending rises. Income rises. And, if the Fed sells bonds …

The Transmission Mechanism of Monetary Policy Assume: money multiplier is 2.5 interest rates change by 1% per $80b ΔMS investment changes by $35b per 1% Δr income rises $5 for each $1 increase in spending How much will income change by if the Fed buys $10 billion worth of bonds? How much will income change by if the Fed sells $15 billion worth of bonds?

Are Monetary Policies Effective? In the Short Run only: If they are unexpected. If wage/price rigidities persist. Over time, these should be less likely. How effective? The liquidity effect – How responsive are interest rates to changes in the money supply? [∆i is 3% …] The interest elasticity of investment – How responsive is investment to a change in interest rates? [∆I is $50 b. …]

Velocity of M1: 1970 - 2015

Velocity of M2: 1970 - 2015

Velocity of MZM: 1970 - 2015

Monetarist vs. Keynesian What are the initial causes of a recession?  Money Supply  Investment The Fed as source. Lack of “animal spirits.” How fast can the economy recover? Very fast. Not very fast. Gov’t as source of disruption. Market instability. Markets are quite robust. May have long-term unemployment problem. How does monetary policy help? It has a direct effect on consumer spending. Works through effects on investment spending. Very powerful. Likely ineffective. “Pushing on a string.”

Monetarist vs. Keynesian Should the government aid in the recovery from recession? No. Yes. Use rules. Use discretion. Monetary rules will provide the necessary effect. Fiscal policies, especially gov’t spending are best. What about increase both government spending and taxes, to maintain a balanced budget?  Government spending has dubious effects.  Government spending is the key to success.  Taxes will slow down economic growth.  Taxes will be more than offset by  gov’t spending.

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

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

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.

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.

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

Monetary Theory: The AD/AS Model – Pt. II ECO 473 – Money & Banking – Dr. D. Foster