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

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?

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