Monetary Theory: The AD/AS Model – Pt. I 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

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 Q1 B P1 Q2 AD1 Q or R-GDP

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.

Can’t do “all else equal.” Aggregate Demand Can’t do “all else equal.” e.g. Price of apples - QD for apples ... and the QD for 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!

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

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

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)

Money and Aggregate Demand Equation of exchange: An accounting identity: Ms * V = P * Q Quantity theory of money: (MD  Ms) * V = P * Q where MD  Ms Velocity is constant Q is at full employment Note: Velocity is the inverse of “k” from the money demand formula. Also P*Q is used here instead of P*y Therefore, changes in M will only change P. Aggregate Demand for output (AD) can be derived from the demand for money.

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

“Inflation is always, and everywhere, a monetary phenomenon.” The Money Supply and the Long Run Equilibrium between Aggregate Demand and Aggregate Supply MS and that increases AD. MS and that decreases AD. P 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

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 income. 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*

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