Download The End of the Classical Dichotomy

The End of the Classical Dichotomy
So far, in our analysis, we have made several useful assumptions about economies
which have been useful in analyzing the long term effects of economic policies and
economic events on the employment, capital accumulation, production, terms of trade,
inflation and the exchange rate. The primary assumption that we have made is that
nominal prices, the prices of goods in terms of currency respond quickly to changes in
the economy. This assumption is not realistic in the short term, but we know that
given time, prices will adjust. So our analysis is an analysis of the long term, an
analysis of the effect of events or policies after prices have had a chance to adjust.
However, it becomes clear from looking at some simple economic history, that the
economy in Hong Kong experiences substantial short run fluctuation in production.
This is a phenomenon we definitely want to explain, because unemployment is
closely related to economic growth.
Aggregate Supply and Aggregate Demand
Classical Approach to Aggregate Supply
This approach argues that there is a fixed amount of capital given by a
country's long run capital fundamentals and fixed available labor given by the
fundamentals of the labor market. This means there is a fixed amount of production
that will be done. Thus, output is fixed solely by supply and has nothing to do with
demand.
AS
Y
Monetarist Approach to Aggregate Demand
We can then develop our definition of velocity to form a relationship between the
amount of money available and an amount of goods that are spent. This says that
M*V=P*Y
Assume that households want to hold a constant percentage of Nominal GDP for
purchases at any given time (k = 1/V):
M=kPY
M
kY
We can call this our aggregate demand curve. Our exogenous variables are money and
velocity and the endogenous variables are price and output.
P
P
M,V
AD
M,V
VVV
VV
This diagram neatly demonstrates the effect of money and velocity on the price level
in the long run. With output fixed by real factors, an increase in the money supply (or
velocity will lead to an increase in the price level.
P
AS
M
AD1
AD0
The Monetarist Theory of Fluctuations puts the effects of the money supply in a
different light. Under this thinking, the money supply fluctuates much more quickly
than firms are able to change prices. In the short run, it might be more plausible to
think about firms supply being set to keep prices constant.
P
M
SRAS
AD1
AD0
If prices are to remain constant when the supply of money available to buy goods
goes up, firms must increase their level of output to keep up with the extra demand.


In the short run, firms hire extra workers to meet higher production targets.
Unemployment drops (whats going on in labor markets?)
In the long run, firms raise prices. Long run equilibrium is restored.
P
M
SRAS
AD1
AD0
In the short run an expansion in aggregate demand will lead to an increase in output,
but in the long run, it will only lead to an increase in prices.
Stabilization
In this context, we can examine the effect of money demand shocks and money
supply shocks. First consider an increase in the share of GDP that people will want to
keep on hand. This will reduce the velocity of money, and lead to a drop in aggregate
demand. This will lead to a drop in output and then eventually to a drop in prices.
P
AD1
AD0
V
SRAS0
Y
On the other hand, the Central Bank can control the money supply
P
AD1
AD0
V
SRAS0
M
Y
However, stabilizing in the face of a temporary supply shock, may be more difficult.
One way to think of sticky prices is that firms charge a markup over their cost of
materials, but the markup itself is sticky. What if materials prices go up, the price that
firms charge will go up:
P
AD0
V
SRAS1
SRAS0
Y
The Central Bank can preserve employment, but only at the cost of permanently
increasing prices.
P
AD0
AD1
V
SRAS1
SRAS0
Y
The Central Bank can preserve employment, but only at the cost of permanently
increasing.
Two key questions about fluctuations need to be asked about short run economic
fluctuations:
1. What causes velocity to fluctuate?
2. How do fluctuations affect the components of demand (consumption, investment,
and net exports?)
3. What causes fluctuations in a small open economy?