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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
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…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
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