monetary theory: eco 285 – macroeconomics – dr. d. foster the ad/as model
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Monetary Theory:Monetary Theory:
ECO 285 – Macroeconomics – Dr. D. Foster
The AD/AS ModelThe AD/AS Model
Warning .. Warning .. WarningWarning .. Warning .. Warning
• Aggregate Supply and Aggregate Demand are not Aggregate Supply and Aggregate Demand are not like market supply & demand !!!!!like market supply & demand !!!!!
• The “static” analysis only hints at dynamic The “static” analysis only hints at dynamic interpretation.interpretation.
• Ceteris Paribus assumption problematic to the point Ceteris Paribus assumption problematic to the point of being wholly inappropriate.of being wholly inappropriate.
Contrasting views:Classical/Monetarist vs.
KeynesianFriedman vs. Keynes
Non-activist vs. Activist
The Aggregate Demand ScheduleThe Aggregate Demand Schedule
AD1
P
Q or R-GDP
BP1
Q2
AP2
Q1
P = Price Level;CPI or GDP deflator
Q = Y = Real GDP; (real output)
AD = Agg. Demand;From 4 sectors – HH, Bus, G, Foreign
Aggregate DemandAggregate Demand
• The price level and real output demanded are The price level and real output demanded are inversely related.inversely related.
• A fall in the price level will increase quantity A fall in the price level will increase quantity demanded.demanded.
• Why? -- the Why? -- the Real Balances EffectReal 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 DemandAggregate Demand
• What about:What about:
Interest effectInterest effect Foreign trade effectForeign trade effect Exchange rate effectExchange rate effect
• AD can shift to the left or right.AD can shift to the left or right.
Increase AD – shift to the right.Increase AD – shift to the right.
Decrease AD – shift to the left.Decrease AD – shift to the left.
Whenever C, I, G, net X increase/decrease.Whenever C, I, G, net X increase/decrease.
Why? Due to changes in the money supply!Why? Due to changes in the money supply!
Can’t do “all else equal.”Can’t do “all else equal.” e.g. e.g. Price of apples - Price of apples - QQDD for apples ... for apples ...
and the and the QQDD for oranges. for oranges.
But, But, Price of everything and their isn’t Price of everything and their isn’t anything else to hold constant! anything else to hold constant!
The Aggregate Demand ScheduleThe Aggregate Demand Schedule
AD2
AD1
P
Q or R-GDP
AD3
Increases inC, I, G, net
X
Decreases in
C, I, G, net X
Money and Aggregate DemandMoney 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
AD2 MS/(k*P)
AD1
P
Q or R-GDP
AD3 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 ScheduleQTM & The Aggregate Demand Schedule
The Money Supply and the Long Run Equilibrium The Money Supply and the Long Run Equilibrium between Aggregate Demand and Aggregate Supplybetween Aggregate Demand and Aggregate Supply
It is unaffected by changes in the price level, but is
affected by a host of real variables…
AD1
P
Q or R-GDP
ASLR
P1
Classical Model of the Economy
There is a “long run” Aggregate Supply,which is perfectly
verticalat the “full
employment”level of Real GDP.
The Money Supply and the Long Run Equilibrium The Money Supply and the Long Run Equilibrium between Aggregate Demand and Aggregate Supplybetween Aggregate Demand and Aggregate Supply
MS and that increases AD. MS and that
decreases AD.
AD1
P
Q or R-GDP
AS1
P1
Shifts in AD can only change the price level
and not real output (nor employment).
““Inflation is always, Inflation is always, and everywhere, a and everywhere, a
monetary monetary phenomenon.”phenomenon.”
-Milton Friedman
What affects the Aggregate Supply?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 InflexibilityShort Run Aggregate Supply – Wage Inflexibility
• Nominal wages are sluggishsluggish upwards:A rise in prices has delayed effect on wages.
• Nominal wages are inflexibleinflexible downwards:A fall in prices will result in employment and y.
• Workers have money illusionmoney 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%…e.g. if prices rise 5% and wages rise 3%…
Short Run Aggregate SupplyShort 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 pricesSticky prices MisperceptionMisperception Intertemporal substitutionIntertemporal substitution
Unnecessary complicationsUnnecessary complicationsto explain the SR AS.to explain the SR AS.
Inflexible wages is all we need.Inflexible wages is all we need.
What happens if there is a AD?
From SR to LR Aggregate SupplyFrom SR to LR Aggregate Supply
An increase An increase in AD triggers in AD triggers
events.events.
Prices rise,Prices rise,wages lag,wages lag,
output output risesrises..
Eventually,Eventually,wages catch upwages catch up
and AS declines.and AS declines.
In LR, In LR, onlyonlyprices riseprices rise..AD
1
P
Q or R-GDP
ASLR
P1
AS1
AD2
P2
Q2Q*
P3
AS2
AS3
AS/AD Model – Hints at 4 types of changesAS/AD Model – Hints at 4 types of changes
• Inflation with growth due Inflation with growth due to rising AD.to rising AD.
• Depression with deflation Depression with deflation due to falling AD.due to falling AD.
• Growth with deflation due Growth with deflation due to rising AS.to rising AS.
• Depression with inflation Depression with inflation due to falling AS. due to falling AS. (stagflation)(stagflation)
AD1
P
Q or R-GDP
ASLR
P1
AS1
Q*
Are Monetary Policies Effective?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, 1960-2013Velocity of M1, M2 and MZM, 1960-2013
Persistent inflation & inflationary expectationsPersistent inflation & inflationary expectations
The Fed tries to reduce The Fed tries to reduce unemployment and unemployment and increase output by increase output by MS. This MS. This AD.AD.
AD1
P
Q or R-GDP
P1
AS1
AD2
Q*
P3
AS2AS3
AD2
AS4
P2
AS5
P4 With a lag, the AS will decrease so all we see is P.
The Fed keeps trying, The Fed keeps trying, but now no lag in but now no lag in AS.AS.
If the Fed stops If the Fed stops inflationary inflationary expectations expectations will continue to will continue to AS, now AS, now Q.Q.
Monetarist vs. KeynesianMonetarist 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 SupplyMonetarist vs. Keynesian Short Run Aggregate Supply
The AS is flat in The AS is flat in the the KeynesianKeynesian view and steep view and steep according to the according to the
MonetaristsMonetarists..
So, a decrease in So, a decrease in the AD will have the AD will have
different different consequences in consequences in the two theories.the two theories.
AD1
P
Q or R-GDP
ASLR
P1
AS - Keynes
Q*
AS - Monetarist
AD2
Other observations on the Business CycleOther observations on the Business Cycle
Can we eliminate inflation by Can we eliminate inflation by AS (short run)?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 CycleOther observations on the Business Cycle
To eliminate inflation we must To eliminate inflation we must AD.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?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 QuestionsCurrent Problems & Policy Questions
AD
Q = Real GDP
P1
Prices
Q*
ASLR
ASSR
AD’
Q’
P2
•Decreased AD Decreased AD sends us into sends us into recession.recession.
AD’’
P3
AD’’’
•Fed expands the MS Fed expands the MS to stimulate economic to stimulate economic growth. Doesn’t work.growth. Doesn’t work.
•Eventually, there’s Eventually, there’s an overreaction.an overreaction.
•Sharply rising AD Sharply rising AD leads to high levels of leads to high levels of inflation.inflation.
What will be the effect of the
Fed’s having MB to $4 tr and TR
to $2.6 tr?
Monetary Theory:Monetary Theory:
ECO 285 – Macroeconomics – Dr. D. Foster
The AD/AS ModelThe AD/AS Model
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