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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 Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 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 Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 26-3 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 Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 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 Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 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 Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 26-6 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 Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 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 Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 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 Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 26-9 FIGURE 26.1 Monetarist response to declines in exogenous investment: Income remains at the full employment level. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 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 Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 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 Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 26-12 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 Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 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 Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 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 Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 26-15 FIGURE 26.2 Keynesian response to declines in exogenous investment: Income falls below full employment level. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 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 Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 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 Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 26-18 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 Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 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 Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 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 Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 26-21 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 Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 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 Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 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 Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 26-24 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 Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 26-25 FIGURE 26.3 Anything shifting aggregate demand to the right causes inflation Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 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 Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 26-27 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 Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 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 Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 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 Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 26-30 The graph of a Phillips curve looks like this Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 26-31 FIGURE 26.4 Inflation causes higher income (and lower unemployment) with a positively sloped supply curve. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 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 Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 26-33 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 Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 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 Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 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 Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 26-36 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 Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 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 Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 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 Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 26-39 FIGURE 26.5 Friedman’s alleged perverse effects of countercyclical monetary policy. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 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 Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 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 Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 26-42 FIGURE 26.6 Aggregate demand and supply shifting together over time according to a fixed monetary rule. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 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 Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 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 Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 26-45