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 Assume: money multiplier is 2.5 interest rates change by 1% per $80b ΔMS investment changes by $35b per 1% Δi income rises $5 for each $1 increase in spending (AD) 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 - 2017 2017 Q3: 5.5

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. 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.” Should the government aid in the recovery? No – use rules. Yes – use discretion.

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.” Wage & price controls Tax-based Incomes policies (TIPs) To eliminate inflation we must AD We’ll have to contend with inflationary expectations. Gradualism approach Going cold turkey

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, and sharply rising AD leads to high levels of inflation. P1 AD Q’ P2 AD’’ AD’ Will this be the result of the Fed’s having MB to $4.5 tr and ER to $2.6 tr? Q = Real GDP Q*

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