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API-120 - Prof. J. Frankel, Harvard University (III) MONEY & INFLATION LECTURE 6: AGGREGATE DEMAND & AGGREGATE SUPPLY In lectures 3-5 we saw the effects of monetary expansion, ΔM, on income, ΔY. Question 1: How do these results change when taking into account changes in the price level, P? Question 2: What are the effects on P & Y 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.
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AGGREGATE DEMAND Everything we have learned so far, about the effects of demand expansion, including monetary & fiscal policy, now goes into the AD relationship, API-120 - Prof. J. Frankel, Harvard University but holds only for a give price level P. The Aggregate Demand curve allows the price level to vary.
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API-120 - Prof. J. Frankel, Harvard University Slope of AD: Shift of AD: negative Aggregate Demand Curve y p p y AD AD'
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API-120 - Prof. J. Frankel, Harvard University OVERVIEW OF AGGREGATE SUPPLY y p y p AD' AS Realistic in Very Short Run. Realistic in Long Run.
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API-120 - Prof. J. Frankel OVERVIEW OF AGGREGATE SUPPLY (continued) ● Intermediate case: AS has some slope in the SR; p y AD initial AS short run So a monetary expansion initially goes into both P and Y.
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API-120 - Prof. J. Frankel, Harvard University In response to the output fall in the great recession …. Financial Times, Sept. 2015 An upward-sloping supply relationship:
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…inflation fell everywhere in 2009. World Bank, June 2014. Global Ec. Prospects. “Exchange rate pass-through and inflation trends in developing countries,” Global Ec. Prospects Source: IMF WEO, 2015
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API-120 - Prof. J. Frankel OVERVIEW OF AGGREGATE SUPPLY (continued) Milton Friedman where π ≡ p – p -1 and π e ≡ p e – p -1. σ ≡ elasticity of aggregate supply (b in Romer book). Can be modeled via: sticky wage W which adjusts over time, ● Intermediate case: AS has some slope in the SR; but is vertical in the Long Run. SR supply relationship:
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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 => i ). An increase in the expected future rate of growth of M shifts IS out, because e => r => A . (See next slide). Either way, r , IS-LM shifts right => AD shifts right. => Y↑ for given P => AD shifts right. API-120 - Prof. J. Frankel, Harvard University p pepe y AD initial AD expanded AS short run AS long run
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API-120 - Prof. J. Frankel 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 => “Mundell-Tobin effect.”
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Over time, P rises in response to high AD & Y. In LR, P rises in same proportion as M. ≡ “Neutrality of money.” API-120 - Prof. J. Frankel, Harvard University STANLEY FISCHER (MIT PRESS, 2004)
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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-Tobin effect) => A => Y . LR: r, A & Y back to original levels (super-neutrality). i by same as π e (Fisher effect) => M/P . API-120 - Prof. J. Frankel, Harvard University
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Appendix 1 -- What lessons will monetary theory take from the 2008 global financial crisis? One is that excessive credit 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. API-120 - Prof. J. Frankel, Harvard University
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Appendix 2 – Example of overheating: China in 2006-08 Growth > 10% in 2006-07
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China ’ s CPI accelerated in 2007-08 API-120 - Prof. J.Frankel, Harvard Source: HKMA, Half-Yearly Monetary and Financial Stability Report, June 2008 Inflation 1999 to 2008
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