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

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? Change in the monetary base = +$10 billion Change in the money supply = +$25 billion Change in interest rates = -0.3125% Change in investment = +$10.9 billion Change in income = +$54.7 billion 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 - 2017 2017 Q3: 5.5

Velocity of M2: 1970 - 2017 2017 Q3: 1.43

Velocity of MZM: 1970 - 2017 2017 Q3: 1.296

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 & the SR AS 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 ER to $2.6 tr? Was Obama a Keynesian? Q = Real GDP Q*

Monetary Transmission Mechanism – Pt.I Where we have the following information: The money multiplier is 3.25, or is derived from the formula. Interest rates will change by 1.5% for each $65 billion change in the money supply. Investment will change by $122 billion for each 2% change in interest rates. Income will change by $7 for each $2 change in investment. The unemployment rate will change by .46% for each $150 billion change in income, up to a maximum change of +1.84%. If the change in income exceeds +$600 billion, the effects will be strictly inflationary (if income rises) or deflationary (if income falls). For each additional $150 billion in income, the inflation rate will change by 2.1%.

Monetary Transmission Mechanism – Pt.I 1. What will be the impact on income, unemployment and inflation if the Fed buys $15 billion worth of bonds?   2. What will be the impact on income, unemployment and inflation if the Fed sells $25 billion worth of bonds? 3. If the Fed wants to raise income by $350 billion, how much should it buy/sell in Treasury bonds? 4. If the Fed wants to lower the unemployment rate by 1%, how much should it buy/sell in Treasury bonds?

Monetary Transmission Mechanism – Pt.2 Recalculate problem #1 where the required reserve ratio is 15%, the desired excess reserve ratio is 5% and the currency ratio is 75%. Let your calculated impact on income and unemployment be the Fed’s targets.   a. Let’s begin this problem again, except that there has been increased pessimism in the market and the following changes have occurred that the Fed didn’t count on, as follows: the desired excess reserve ratio rises to 50%. the desired currency ratio rises to 100% interest only changes by .75% for each $65 billion change in the MS investment only changes by $66 billion for each 2% change in interest Calculate the effect of the Fed’s policy.

Monetary Transmission Mechanism – Pt.2 b. Clearly the Fed didn’t reach its target, so they try again, but with an increase amount of bond purchases of $85 billion. But, once again there has been increased pessimism in the market and the following changes have occurred that the Fed didn’t count on: the desired excess reserve ratio rises to 95%. the desired currency ratio rises to 125% interest only changes by .4% for each $65 billion change in the MS investment only changes by $36 billion for each 2% change in interest Calculate the effect of the Fed’s policy.

Monetary Transmission Mechanism – Pt.2 c. That still didn’t work, so the Fed tries once again. This time they buy even more bonds: $250 billion! Well, that should do the trick. Except now, there have been further changes, representing a wave of optimism, as follows: the desired excess reserve ratio falls to 15%. the desired currency ratio falls to 60% interest only changes by 1.5 % for each $65 billion change in the MS investment only changes by $122 billion for each 2% change in interest Calculate the effect of the Fed’s policy.

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