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(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. AGGREGATE DEMAND • Everything we have learned so far, about the effects of demand expansion, including monetary & fiscal policy, now goes into the AD relationship, but holds only for a give price level P. • The Aggregate Demand curve allows the price level to vary. API-120 - Prof. J. Frankel, Harvard University Aggregate Demand Curve Slope of AD: negative Shift of AD: 𝑀 𝑃 P↑ => ↓ => LM shifts left => Y ↓ . Spending increase Ā ↑ shifts AD right p AD y p (by multiplier, less crowding out). Money increase M ↑ shifts AD up (in direction proportion to M). API-120 - Prof. J. Frankel, Harvard University AD AD' y OVERVIEW OF AGGREGATE SUPPLY Ultra-Keynesian case: AS flat, at 𝑃 => AD expansion goes entirely into Y. AD' p AS Realistic in Very Short Run. y Classical case AS vertical at 𝑌 => AD expansion goes entirely into P. AS p AD' Then only AS shocks move Y = 𝑌, e.g., productivity shocks. (RBC models.) Realistic in Long Run. 𝑦 API-120 - Prof. J. Frankel, Harvard University y ● Intermediate case: AS has some slope in the SR; So a monetary expansion initially goes into both P and Y. E.g., Y > 𝑌. Over time P responds to excess demand until Y is back at 𝑌. • • What if the economy is found to be in excess p supply: Y < 𝑌? • e.g., in the aftermath of a fall in 𝐼? • Eventually P will respond by falling enough to restore Y= 𝑌. • But that might be a long painful recession. • The government could expand demand to speed it up. • • • 𝑦 API-120 - Prof. J. Frankel • AS short run AD initial y An upward-sloping supply relationship: In response to the output fall in the great recession …. Financial Times, Sept. 2015 API-120 - Prof. J. Frankel, Harvard University …inflation fell everywhere in 2009. IMF, April 2016, WORLD ECONOMIC OUTLOOK http://www.imf.org/external/pubs/ft/weo/2016/01/pdf/text.pdf Source: IMF WEO Oct. 2015 ● Intermediate case: AS has some slope in the SR; but is vertical in the Long Run. SR supply relationship: Can be modeled via: wage W is sticky, but adjusts over time. 𝑌 𝑌 = 𝑃 σ (ω ) 𝑊 σ ≡ elasticity of aggregate supply (b in Romer book). E.g., wage contract 𝑊 = ω 𝑃𝑒 . 𝑌 or in logs, = 𝑃 𝑃𝑒 σ 𝑌 y - 𝑦 = σ [𝑝 − 𝑝𝑒 ] = σ [ 𝑝−p−1 − 𝑝𝑒 −p−1 ] The Phillips curve: y − 𝑦 = σ (π − π𝑒 ) where π ≡ p – p-1 Milton Friedman and πe ≡ pe – p-1 . Over time, expectations adjust in response to actual inflation, as does W. Monetary expansion raises AD in the SR An increase in the current level of M shifts AD curve out (again, because M/P in the SR shifts out LM curve => i => A ). ● Over time: • Observed rise in P raises 𝑃𝑒 and therefore 𝑊, when contract is re− negotiated after 1st year. • => AS shifts up. • W and P continue to adjust until, in the LR, Y is back at 𝑌. • p −𝑝 2 -- • 𝑦 API-120 - Prof. J. Frankel • AS short run 𝑒 −𝑝𝑒 1 -- y - 𝑦 = σ (𝑝 − 𝑝𝑒 ) AD initial y STANLEY FISCHER (MIT PRESS, 2004) • In LR, P rises in same proportion as M. • ≡ “Neutrality of money.” API-120 - Prof. J. Frankel, Harvard University What about an increase in expected rate of growth of M, as opposed to the level? Example: in Jan. 2013, Bank of Japan raised target to 2 % (Abenomics). An increase in the expected future rate of growth of M shifts IS out, because e AS long run => r p => A . • (See next slide). Either way, r , IS-LM shifts right => AD shifts right. pe • AS short run AD expanded AD initial 𝑦 API-120 - Prof. J. Frankel, Harvard University y 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.” SUMMARY OF EFFECTS OF 2 EXPERIMENTS • Increase in level of M: • Increase in growth rate of M (gM in Romer book): 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. SR: => πe => r (Mundell-Tobin effect) => A => Y . • LR: r, A & Y back to original levels (super-neutrality). i by same as πe (Fisher effect) => M/P . API-120 - Prof. J. Frankel, Harvard University 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 Appendix 2 – Example of overheating: China in 2006-08 Growth > 10% in 2006-07 China’s CPI accelerated in 2007-08 Inflation 1999 to 2008 Source: HKMA, Half-Yearly Monetary and Financial Stability Report, June 2008 API-120 - Prof. J.Frankel, Harvard