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

Warning.. Warning.. Warning Aggregate Supply and Aggregate Demand are not like market supply & demand !!!!!Aggregate Supply and Aggregate Demand are not like market supply & demand !!!!! The “static” analysis only hints at dynamic interpretation.The “static” analysis only hints at dynamic interpretation. Ceteris Paribus assumption problematic to the point of being wholly inappropriate.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 AD 1 P Q or R-GDP B P1P1 Q2Q2 A P2P2 Q1Q1 P = Price Level; CPI or GDP deflator Q = Y = Real GDP; (real output) AD = Agg. Demand; From 4 sectors – HH, Bus, G, Foreign

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

Aggregate Demand What about:What about:  Interest effect  Foreign trade effect  Exchange rate effect AD can shift to the left or right.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! Can’t do “all else equal.” e.g.  Price of apples -  Q D for apples... and the  Q D for oranges. e.g.  Price of apples -  Q D for apples... and the  Q D for oranges. But,  Price of everything and their isn’t anything else to hold constant! But,  Price of everything and their isn’t anything else to hold constant!

The Aggregate Demand Schedule AD 2 AD 1 P Q or R-GDP AD 3 Increases in C, I, G, net X Decreases in C, I, G, net X

Money and Aggregate Demand Equation of exchangeEquation of exchange:  An accounting identity: Quantity theory of moneyQuantity 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. MS * V = P * Y MD = k * P * Y

AD 2  MS/(k*P) AD 1 P Q or R-GDP AD 3  MS/(k*P) Increases in MS Decreases in MS MD = MS MS = k * P * Y MS/(k * P) = Y AD = MS/(k * P) QTM & The Aggregate Demand Schedule

The Money Supply and the Long Run Equilibrium between Aggregate Demand and Aggregate Supply It is unaffected by changes in the price level, but is affected by a host of real variables… AD 1 P Q or R-GDP AS LR P1P1 Classical Model of the Economy There is a “long run” Aggregate Supply, which is perfectly vertical at the “full employment” level of Real GDP.

The Money Supply and the Long Run Equilibrium between Aggregate Demand and Aggregate Supply  MS and that increases AD.  MS and that decreases AD. AD 1 P Q or R-GDP AS 1 P1P1 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

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)

Short Run Aggregate Supply – Wage Inflexibility sluggishNominal wages are sluggish upwards:  A rise in prices has delayed effect on wages. inflexibleNominal wages are inflexible downwards:  A fall in prices will result in  employment and  y. money illusionWorkers 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 The Short Run will adjust to the Long RunThe 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: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?

From SR to LR Aggregate Supply An increase in AD triggers events. Prices rise, wages lag, output rises. Eventually, wages catch up and AS declines. In LR, only prices rise. AD 1 P Q or R-GDP AS LR P1P1 AS 1 AD 2 P2P2 Q2Q2 Q* P3P3 AS 2 AS 3

AS/AD Model – Hints at 4 types of changes Inflation with growth due to rising AD.Inflation with growth due to rising AD. Depression with deflation due to falling AD.Depression with deflation due to falling AD. Growth with deflation due to rising AS.Growth with deflation due to rising AS. Depression with inflation due to falling AS. (stagflation)Depression with inflation due to falling AS. (stagflation) AD 1 P Q or R-GDP AS LR P1P1 AS 1 Q*

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.

Velocity of M1, M2 and MZM,

Persistent inflation & inflationary expectations The Fed tries to reduce unemployment and increase output by  MS. This  AD. AD 1 P Q or R-GDP P1P1 AS 1 AD 2 Q* P3P3 AS 2 AS 3 AD 2 AS 4 P2P2 AS 5 P4P4 With a lag, the AS will decrease so all we see is  P. The Fed keeps trying, but now no lag in  AS. If the Fed stops inflationary expectations will continue to  AS, now  Q.

Monetarist vs. Keynesian 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

Monetarist vs. Keynesian Short Run Aggregate Supply The AS is flat in the Keynesian view and steep according to the Monetarists. So, a decrease in the AD will have different consequences in the two theories. AD 1 P Q or R-GDP AS LR P1P1 AS - Keynes Q* AS - Monetarist AD 2

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 controlsWage & price controls Tax-based Incomes policies (TIPs)Tax-based Incomes policies (TIPs) Supply-side incentives to boost output.Supply-side incentives to boost output. Remove barriers that keep wages/prices from falling.Remove barriers that keep wages/prices from falling.

Other observations on the Business Cycle  To eliminate inflation we must  AD. But, we’ll have to contend with inflationary expectations. How? Gradualism approachGradualism approach Going cold turkeyGoing cold turkey IndexingIndexing Wages, mortgage interest rates, taxes …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 Q = Real GDP P1P1 Prices Q*Q* AS LR AS SR AD ’ Q’Q’ P2P2 Decreased AD sends us into recession.Decreased AD sends us into recession. AD ’’ P3P3 AD ’’’ Fed expands the MS to stimulate economic growth. Doesn’t work.Fed expands the MS to stimulate economic growth. Doesn’t work. Eventually, there’s an overreaction.Eventually, there’s an overreaction. Sharply rising AD leads to high levels of inflation.Sharply rising AD leads to high levels of inflation. What will be the effect of the Fed’s having  MB to $4 tr and  TR to $2.6 tr?

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