Copyright 2007 Jeffrey Frankel, unless otherwise noted API Macroeconomic Policy Analysis I Professor Jeffrey Frankel, Kennedy School of Government, Harvard University LECTURE 5: AGGREGATE SUPPLY, MONEY GROWTH, & INFLATION In lectures 2-4 we saw the effects of expansion in spending or the money supply level, M, on income, Y. Question 1: How do these results change when taking into account changes in P? Question 2: What are the effects of an increase in the rate of growth of money? Key parameter(s) in goods market: SR elasticity of supply, , and speed of adjustment of P over time.

AGGREGATE DEMAND Everything we have learned so far, about the effects of demand expansion, including monetary and fiscal policy, now goes into the AD relationship, but holds only for a give price level P. The Aggregate Demand curve allows the price level to vary. Copyright 2007 Jeffrey Frankel, unless otherwise noted API Macroeconomic Policy Analysis I Professor Jeffrey Frankel, Kennedy School of Government, Harvard University

Copyright 2007 Jeffrey Frankel, unless otherwise noted API Macroeconomic Policy Analysis I Professor Jeffrey Frankel, Kennedy School of Government, Harvard University Slope of AD: Shift of AD downward

Copyright 2007 Jeffrey Frankel, unless otherwise noted API Macroeconomic Policy Analysis I Professor Jeffrey Frankel, Kennedy School of Government, Harvard University OVERVIEW OF AGGREGATE SUPPLY  Ultra-Keynesian case: AS flat, at => AD expansion goes entirely into Y. Y P Y P AD' AS  Classical case AS vertical at => AD expansion goes entirely into P. Realistic in Very Short Run. Realistic in Long Run.

Copyright 2007 Jeffrey Frankel, unless otherwise noted API Macroeconomic Policy Analysis I Professor Jeffrey Frankel, Kennedy School of Government, Harvard University OVERVIEW OF AGGREGATE SUPPLY (continued) Milton Friedman Robert Lucas ●

Copyright 2007 Jeffrey Frankel, unless otherwise noted API Macroeconomic Policy Analysis I Professor Jeffrey Frankel, Kennedy School of Government, Harvard University Monetary expansion raises AD in the SR  An increase in the current level of M shifts LM curve out (because M/P  in the SR).  An increase in the expected future rate of growth of M shifts IS out, because  e  => r  => A . (See next page).  Either way, IS-LM shifts right => AD shifts right: => Y↑ for given P => AD shifts right.

Copyright 2007 Jeffrey Frankel, unless otherwise noted API Macroeconomic Policy Analysis I Professor Jeffrey Frankel, Kennedy School of Government, Harvard University The real interest rate & the cost of capital Business investment, & other components of spending A, depend not just on the nominal interest rate i, but on the real interest rate r ≡ i -  e. (To compute corporate cost of capital, it should also be long-term i, and adjusted for taxes.) This becomes important when we allow for steady-state rate of change in M & P, i.e., inflation. Generally,  e  is not fully reflected in i in SR. So => r  => A  => IS shifts right.

Copyright 2007 Jeffrey Frankel, unless otherwise noted API Macroeconomic Policy Analysis I Professor Jeffrey Frankel, Kennedy School of Government, Harvard University Over time, P rises in response to high AD & Y. In LR, P rises in same proportion as M. ≡ “Neutrality of money.” STANLEY FISCHER (MIT PRESS, 2004)

SUMMARY OF EFFECTS OF 2 EXPERIMENTS Increase in level of M: SR: => M/P  => i  (liquidity effect) => r  => A  => Y . LR: M/P, i, r, A & Y back to original levels (neutrality of money). P  in proportion to M. <= Increase in growth rate of M (g M in Romer book): SR: => π e  => r  (Mundell effect) => A  => Y . LR: r, A & Y back to original levels (super-neutrality). i  by same as π e (Fisher effect) => M/P .

Copyright 2007 Jeffrey Frankel, unless otherwise noted API Macroeconomic Policy Analysis I Professor Jeffrey Frankel, Kennedy School of Government, Harvard University INTELLECTUAL HISTORY OF THE INCREASING INEFFECTIVENESS OF MONETARY POLICY Monetary expansion can raise Y: A.S. -- at the cost of higher P. Phillips curve (1958) -- at the cost of higher inflation, . Friedman & Phelps (1968) at the cost of ever-accelerating  Natural Rate Hypothesis. -- (because π e adjusts over time to π). Lucas, Sargent, Barro ( ) only randomly Rational Expectations -- (because π-π e must be random). Kydland-Prescott (1977) & Barro- and, worse yet: monetary discretion Gordon (1983). Time-inconsistency -- => inflationary bias. E.g., Bruno-Easterly (1998) & High  (>40%) hurts growth Dornbusch-Fischer (1993) -- in the LR. (Table 2) (Chart 1)

The Mexican sexenio From 1976 through 1994, inflation would shoot up every 6 th year (presidential election years). and/or the peso would devalue,

Copyright 2007 Jeffrey Frankel, unless otherwise noted API Macroeconomic Policy Analysis I Professor Jeffrey Frankel, Kennedy School of Government, Harvard University Source: Inflation above a threshold ≈ 40% tends to have a negative effect on growth.

Copyright 2007 Jeffrey Frankel, unless otherwise noted API Macroeconomic Policy Analysis I Professor Jeffrey Frankel, Kennedy School of Government, Harvard University What lesson will monetary theory take from the global financial crises? Perhaps that excessive monetary ease can show up in the form of asset price “bubbles” –which can lead to crashes & recessions, and not necessarily always in the form of inflation – which can lead to crashes & recessions.