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Transcript
Monetary Theory: The AD/AS Model ECO 285 – Macroeconomics – Dr. D. Foster Warning .. Warning .. Warning • Aggregate Supply and Aggregate Demand are not like market supply & demand !!!!! • The “static” analysis only hints at dynamic interpretation. • 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 P P = Price Level; CPI or GDP deflator Q = Y = Real GDP; (real output) A P2 B P1 AD = Agg. Demand; From 4 sectors – HH, Bus, G, Foreign AD1 Q1 Q2 Q or R-GDP Aggregate Demand • The price level and real output demanded are inversely related. • A fall in the price level will increase quantity demanded. • Why? -- the Real Balances Effect • • • • All prices and wages change. But, our fixed money holdings are … well, still fixed! So, with lower prices we feel wealthier. Woo Hoo! And, so we want to buy more stuff. Aggregate Demand • What about: Interest effect Foreign trade effect Exchange rate effect Can’t do “all else equal.” e.g. Price of apples - QD for apples ... and the QD for oranges. But, Price of everything and their isn’t anything else to hold constant! • 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! The Aggregate Demand Schedule P Increases in C, I, G, net X Decreases in C, I, G, net X AD3 AD2 AD1 Q or R-GDP Money and Aggregate Demand • Equation of exchange: MS * V = P * Y An accounting identity: • Quantity theory of money: MD = k * P * Y 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. QTM & The Aggregate Demand Schedule P MD = MS Increases in MS MS = k * P * Y MS/(k * P) = Y AD = MS/(k * P) Decreases in MS AD2 AD1 AD3 MS/(k*P) MS/(k*P) Q or R-GDP The Money Supply and the Long Run Equilibrium between Aggregate Demand and Aggregate Supply P ASLR P1 There is a “long run” Aggregate Supply, which is perfectly vertical at the “full employment” level of Real GDP. It is unaffected by changes in the price level, but is affected by a host of real variables… AD1 Classical Model of the Economy Q or R-GDP The Money Supply and the Long Run Equilibrium between Aggregate Demand and Aggregate Supply P AS1 MS and that increases AD. MS and that decreases AD. Shifts in AD can only change the price level and not real output (nor employment). P1 “Inflation is always, and everywhere, a monetary phenomenon.” -Milton Friedman AD1 Q or R-GDP 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 • Nominal wages are sluggish upwards: A rise in prices has delayed effect on wages. • Nominal wages are inflexible downwards: A fall in prices will result in employment and y. • Workers 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 • 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? • The 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. From SR to LR Aggregate Supply P ASLR AS3 An increase in AD triggers events. AS2 AS1 Prices rise, wages lag, output rises. P3 Eventually, wages catch up and AS declines. P2 P1 AD2 AD1 Q* Q2 Q or R-GDP In LR, only prices rise. AS/AD Model – Hints at 4 types of changes P ASLR AS1 • Inflation with growth due to rising AD. • Depression with deflation due to falling AD. • Growth with deflation due to rising AS. • Depression with inflation due to falling AS. (stagflation) P1 AD1 Q* Q or R-GDP 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, 1960-2013 Persistent inflation & inflationary expectations P3 The Fed tries to reduce unemployment and increase output by MS. This AD. With a lag, the AS will decrease so all we see is P. P2 The Fed keeps trying, but now no lag in AS. P AS4 AS5 AS3 AS2 AS1 P4 P1 AD2 AD2 AD1 Q* Q or R-GDP If the Fed stops inflationary expectations will continue to AS, now Q. 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 P ASLR The AS is flat in the Keynesian view and steep according to the Monetarists. AS - Monetarist AS - Keynes So, a decrease in the AD will have different consequences in the two theories. P1 AD1 AD2 Q* Q or R-GDP 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 controls • Tax-based Incomes policies (TIPs) • Supply-side incentives to boost output. • 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 approach • Going cold turkey • Indexing • 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 Prices • Decreased AD sends us into recession. ASLR ASSR • Fed expands the MS to stimulate economic growth. Doesn’t work. P3 AD’’’ P1 • Eventually, there’s an overreaction. AD P2 AD’’ AD’ Q’ Q* Q = Real GDP • 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: The AD/AS Model ECO 285 – Macroeconomics – Dr. D. Foster