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Chapter 26
An Aggregate
Supply and
Demand
Perspective on
Money and
Economic
Stability
Copyright © 2009 Pearson Addison-Wesley. All rights reserved.
Learning Objectives
• Analyze the debate centering on the stability of the
economy around its full employment level
• Define the role crowding out has in debates between
Keynesian and monetarists
• Explain the Phillips curve and its relevance for fiscal
and monetary policy
• Understand the importance of real versus nominal
interest rates in the discussion of monetary policy
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26-2
Introduction
• The importance of money in explaining aggregate
economic outcomes is a defining distinction between
classical and Keynesian economists
• Monetarists—group of economists who uphold the
classical tradition of nonintervention and believe that
money supply should not be a focus of government
policy as a tool of economic stability
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26-3
1
Introduction (Cont.)
• New Classical Macroeconomists—refining
Monetarists thinking by focusing on rational
expectations
• The important elements of the Monetarists-Keynesian
debate can be articulated within the aggregate supply
and demand framework
–
–
–
–
Stability of the economy
Relative effectiveness of monetary/fiscal policy
The causes of inflation
Consequences for interest rates
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26-4
Is the Private Sector Inherently
Stable?
• Monetarists tend to believe that aggregate
demand will be relatively unaffected by
autonomous shifts in investment spending
• Keynes felt active attempts at stabilization were
necessary to counter entrepreneurial animal
spirits
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26-5
Is the Private Sector Inherently
Stable? (Cont.)
• Monetarists
– Exogenous decrease in investment spending will be
automatically countered by increased consumption or
interest-sensitive investment
– With fixed money stock, quantity theory suggests aggregate
demand will be relatively stable
– Downward shift in investment functions would lower interest
rates, stimulating investment spending and reducing savings
which would offset the drop in investment
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26-6
2
Is the Private Sector Inherently
Stable? (Cont.)
• Monetarists (Cont.)
– Fluctuations in the price level are another source of
stability
• Fixed money stock with lower prices would mean a larger
real supply of money which would stimulate spending
• Larger real supply of money would lower interest rates
and investment spending would increase still further
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26-7
Is the Private Sector Inherently
Stable? (Cont.)
• Keynesians
– The quantity theory linkage between money and aggregate
demand is not a reality
– Interest rates do not necessarily decline following a drop in
investment
– Even if interest rates do decline, no guarantee that it would
induce very much additional spending
– Keynesian response to falling prices suggested by classical
economists is twofold:
• Prices rarely decline
• Spending effects react too slow to restore full employment
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26-8
Is the Private Sector Inherently
Stable? (Cont.)
• Figure 26.1—Monetarists response to declines in
exogenous investment
– Downward sloping demand curve
– Vertical supply curve reflecting the classical assumption that
quantity supplied is fixed at full employment—YFE
– Slope of the aggregate demand curve
• Monetarists
– Quantity theory assumes a direct impact of increased real money
balances on the demand for output
– More real money balance, increased spending
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26-9
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FIGURE 26.1 Monetarist response to
declines in exogenous investment: Income
remains at the full employment level.
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26-10
Is the Private Sector Inherently
Stable? (Cont.)
• Figure 26.1 (Cont.)
– Slope of the aggregate demand curve (Cont.)
• Keynesians
– Many things can intervene between real money balances and demand
– Interest rates may not fall very much since people may simply hold the
additional cash balances
– Direct spending may not be responsive to decreases in interest rate
• This suggests slope of aggregate demand curve is flatter for
Monetarists than for Keynesians—changes in quantity demanded are
more responsive to changes in price
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26-11
Is the Private Sector Inherently
Stable? (Cont.)
• Figure 26.1 (Cont.)
– Stability of the aggregate demand curve—Does it move in
response to a decline in investment
• Monetarists
– Stock of money is the major factor in determining aggregate demand
– With a fixed money supply, there is relatively little movement of the
aggregate demand schedule following exogenous shifts in spending
• Keynesians
– Aggregate demand schedule will be pushed to the left if exogenous
investment falls
– At every price level fewer goods are demanded
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26-12
4
Is the Private Sector Inherently
Stable? (Cont.)
• Economic Stability
– Depends on behavior of the aggregate demand
schedule and shape of aggregate supply curve
– Monetarists approach
• Figure 26.1—vertical aggregate supply at full
employment
• Aggregate demand curve may not shift with reduction in
investment, but remain stable at D, with YFE and P
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26-13
Is the Private Sector Inherently
Stable? (Cont.)
• Economic Stability (Cont.)
– Monetarists approach (Cont.)
• However, if the aggregate demand curve does shift from D
to D′, the following adjustment will occur
–
–
–
–
Resulting unemployment will cause prices to fall toward P′
With reduced prices, real quantity of money increases
This causes aggregate demand to increase along D′
Equilibrium is restored at lower prices, P′, and economy back
at full employment, YFE
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26-14
Is the Private Sector Inherently
Stable? (Cont.)
• Economic Stability (Cont.)
– Keynesian approach
• Figure 26.2—Two cases: 1) horizontal supply curve (S) and 2)
upward sloping supply curve (S′)
• Assume aggregate demand decreases from D to D′
• Short run adjustment (horizontal aggregate supply [S])
– Prices are rigid at P and do not fall
– Economy moves to income level, Y, which represents unemployment
and excess capacity
– No automatic adjustment through falling prices
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26-15
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FIGURE 26.2 Keynesian response to
declines in exogenous investment: Income
falls below full employment level.
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26-16
Is the Private Sector Inherently
Stable? (Cont.)
• Economic Stability (Cont.)
– Keynesian approach (Cont.)
• More realistic adjustment (upward sloping aggregate supply [S′])
– Prices and wages will eventually decline, but at a slow pace
– The economy will reach equilibrium at P′, and Y′, which is below full
employment income level
– The adjustment will result in a higher income level than in the case
where prices do not decline
– Wages and prices do not fall sufficiently to stimulate aggregate
demand along D′ to offset the decrease in exogenous investment
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26-17
Is the Private Sector Inherently
Stable? (Cont.)
• Economic Stability (Cont.)
– Keynesian approach (Cont.)
• Both S and S′ in the Keynesian adjustment represent short run
outcomes
• With continued unemployment, there will be an ongoing downward
pressure on wages and incentives for producers to move back to full
employment
• The Keynesians acknowledge the vertical aggregate supply as the
eventual long run outcome
• However, this final adjustment can take a long time supporting
the Keynesian reliance on monetary and fiscal policy to stimulate
the economy
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26-18
6
Monetary Policy, Fiscal Policy,
and Crowding Out
• With upward sloping aggregate supply curve (Figure
26.2) and a lengthy adjustment period, monetary and
fiscal policies are an option to government
policymakers
• Monetarist approach to monetary policy
– Increasing the money supply will push the aggregate demand
curve to the right
– The transmission mechanism of the increase in money supply
is direct—more money means more spending on goods and
services
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26-19
Monetary Policy, Fiscal Policy,
and Crowding Out (Cont.)
• Keynesian approach to monetary policy
– Increased money supply may shift the aggregate demand to
the right, but the impact is less certain
– Purchases of bonds with extra cash balances will push up
prices and reduce interest rates:
• Cost-of-capital effect—increased investment spending
• Wealth effect—higher bond prices increases consumer wealth which
is translated into more spending
• Exchange rate effect—lower interest rates drives down the value of
the dollar, increasing spending on net exports
• Credit availability effect—lower interest rates means more
borrowing and spending
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26-20
Monetary Policy, Fiscal Policy,
and Crowding Out (Cont.)
• With the tenuous linkage of monetary policy,
Keynesians focus on fiscal policy
• Offset decrease of spending by increasing government
spending or lowering taxes
• Crowding out effect
– Monetarists argue increased government spending will
increase interest rates
– Higher interest rates may inhibit private investment spending
that offsets increased government spending and have little, if
any, effect on aggregate demand
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26-21
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Monetary Policy, Fiscal Policy,
and Crowding Out (Cont.)
• Crowding out effect (Cont.)
– Government fiscal policy merely changes the
proportion of government spending relative to
private spending
– Therefore, in the Monetarist world, execution and
net impact of fiscal has definite monetary
implications
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26-22
Monetary Policy, Fiscal Policy,
and Crowding Out (Cont.)
• Crowding out effect (Cont.)
– While Keynes acknowledged this increase in interest rates,
there is an issue of how the increased government spending is
financed
• Financing by money creation is more expansionary than financing by
bond sales
• Both money creation and bond sales are more expansionary than
financing by increased taxation
• Higher interest rates has a dual effect
– Reducing investment spending,
– People economize on cash balances which supplies part of the additional
money needed for higher transactions
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26-23
Inflation, Money, and the Phillips Curve
• Previous discussion questions effectiveness of
countercyclical government policy
• Expansion of money supply to stimulate economy may
be anticipated and lead to inflation rather than increased
spending
• Debate between Keynesians and Monetarists depends
on whether or not inflation is purely a monetary
phenomenon, which revolves around influences on the
aggregate demand
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26-24
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Inflation, Money, and the Phillips Curve
(Cont.)
• Figure 26.3
– Vertical aggregate supply curve at full employment, YFE
– Monetarists
• The aggregate demand schedule is stable at D, unless the money
supply increases due to action by the Federal Reserve
• This will cause a shift to D′ and D′′, which increases prices from P to
P′ and P′′
• The persistent increase of prices through expanding money supply
results in inflation
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26-25
FIGURE 26.3 Anything shifting aggregate
demand to the right causes inflation
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26-26
Inflation, Money, and the Phillips Curve
(Cont.)
• Figure 26.3 (Cont.)
– Keynesians
• Increase in spending by any group can cause the aggregate demand
curve to shift
• Any ill-timed government policy, fiscal or monetary, with the
economy at full employment can cause inflation
– Therefore, Monetarists view inflation as a direct result of
expansion of money supply by Federal Reserve, whereas
Keynesians do not restrict causes of inflation to monetary
policy
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26-27
9
Inflation, Money, and the Phillips Curve
(Cont.)
• Cost-push inflation
– Can be a result of a leftward shift of the aggregate
supply curve caused by a “supply shock”
– Monetarists argue that such a shock is a “once-andfor-all” phenomenon (energy crisis of the 1970s) and
cannot account for persistent inflation
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26-28
Inflation, Money, and the Phillips Curve
(Cont.)
• Another issue dividing Monetarists and
Keynesians concerns the possibility of a tradeoff between inflation and unemployment
– Monetarists
• Deny the possibility of a trade-off and argue that once
inflation is incorporated into people’s expectations, the
unemployment will revert to its “natural” level
• Figure 26.3 is the Monetarists approach—a vertical
supply curve with no change in GDP just increased prices
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26-29
Inflation, Money, and the Phillips Curve
(Cont.)
– Keynesians
• Figure 26.a1—Support the idea of a trade-off known as
the Phillips Curve—lower rates of unemployment can be
achieved with higher rates of inflation
• Figure 26.4 presents the Keynesian view—an upward
sloping supply curve showing that as prices rise, real
output expands beyond YFE with a lower unemployment
rate
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26-30
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The graph of a Phillips curve looks
like this
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26-31
FIGURE 26.4 Inflation causes higher income
(and lower unemployment) with a positively
sloped supply curve.
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26-32
Inflation, Money, and the Phillips Curve
(Cont.)
• Keynesian rational for an upward sloping aggregate
supply curve
– Output varies positively with prices only when wages change
more slowly than prices
– This is a reasonable assumption because many wage rates are
set contractually, and contracts are not adjusted continuously
– When this occurs, labor’s real compensation falls, more
workers are hired and GDP rises
– This provides the rationale for the trade-off between
inflation and unemployment
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Inflation, Money, and the Phillips Curve
(Cont.)
• Monetarists long-run adjustment
– Eventually inflation reality sets in and workers expect a
continued higher level of price increases and push for wage
demands in line with inflation
– When this occurs, employers no longer find it profitable to
retain the high levels of output and the economy reverts to
full employment, YFE
– Once these adjustments have been made, the aggregate
supply curve becomes vertical and there is no long-run
trade-off
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26-34
Inflation and Interest Rates
• Inflationary expectations are crucial to
explaining how interest rates respond to changes
in the money supply
• The Keynesian view is that increasing the
money supply will lower the interest rate
• Monetarists argue that, in the long-run, an
expansionary monetary policy raises interest
rates, direct opposite to Keynesian view
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26-35
Inflation and Interest Rates (Cont.)
• Monetarist Argument
– Increase in money supply may initially lower interest rates
resulting from purchases of financial assets
– Once aggregate demand responds to the increase in money
supply, the transaction demand for money will increase which
pushes up the interest rate
– Expectations of inflation generated by an expansionary
monetary policy will cause a further increase in the level of
nominal interest rates—the inflation premium
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26-36
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Inflation and Interest Rates (Cont.)
• Monetarist Argument (Cont.)
– However it may take time for the inflation premium
to be fully reflected in nominal rates, resulting in a
decline in the real interest rate
– Therefore, if expansionary efforts by the Federal
Reserve to lower interest rates are fully anticipated,
the result may be higher prices and increased
nominal interest rates
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26-37
Should a Robot Replace the Federal
Reserve?
• If self-correcting mechanisms work properly, no need
for government monetary or fiscal action to stabilize
the economy
• Keynes maintained that these stabilizing forces were
uncertain which prompted the need for countercyclical
monetary and fiscal policies
• However, it is possible that attempts at countercyclical
policies can cause greater instability
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26-38
Should a Robot Replace the Federal
Reserve? (Cont.)
• Milton Friedman, influential Monetarist, recognized the
importance of dealing with lags in the economy and
how these could create instability
– Figure 26.5
– It is possible that attempts to stimulate the economy may take
effect after economy has made self-corrections and is starting
to expand
– In this case the stimulus effect occurs at precisely the wrong
time in the cycle, causing wider fluctuations that would have
occurred if left alone
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26-39
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FIGURE 26.5 Friedman’s alleged perverse
effects of countercyclical monetary policy.
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26-40
Should a Robot Replace the Federal
Reserve? (Cont.)
• Monetarists Fixed Rule Policy
– Based on the inherent destabilizing lags, Monetarists have
discarded the idea of using orthodox monetary policy
– They have concluded that the best stabilization policy is no
stabilization policy at all
– Instead, they advocate a fixed long-run rule—increase the
money supply at a steady and inflexible rate regardless of
current economic conditions
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26-41
Should a Robot Replace the Federal
Reserve? (Cont.)
• Monetarists Fixed Rule Policy (Cont.)
– Figure 26.6—If the growth rate of money is properly selected
there should be balanced growth between aggregate demand
and aggregate supply
• Real economic growth
• Stable prices
• High employment
– The main advantage of this rule is to eliminate forecasting
and lag problems and remove the instability of destabilizing
discretionary countercyclical monetary policy
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26-42
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FIGURE 26.6 Aggregate demand and supply
shifting together over time according to a fixed
monetary rule.
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26-43
Should a Robot Replace the Federal
Reserve? (Cont.)
• Monetarists Fixed Rule Policy (Cont.)
– In March 1975, Congress mandated the Federal Reserve to
“maintain long-run growth of the monetary and credit
aggregates commensurate with the economy’s long-run
potential to increase production”
– In November 1977, this provision was incorporated into the
Federal Reserve Act
– This mandate has forced the Federal Reserve to assess its
policies and achieve a smoother monetary growth
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26-44
Should a Robot Replace the Federal
Reserve? (Cont.)
• Interesting conclusion of this chapter
– Extremists from both the Keynesian and
Monetarist schools have collectively ganged up on
the Federal Reserve
– Suggest that a very limited role of the Fed in
achieving economic stability is the appropriate
action
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26-45
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