Download 23-Aggregate D&S II

Aggregate D&S II
Economic Spectrum
Free Markets Work
Monetariasts
X
Government
Spending
(Fiscal Policy)
is Important
Determinant of
Economic Output
Activist (Keynsian)
Monetary Policy
Keynsians
Government Policy Works
Money Supply is
Important
Determinant of
Economic Output
Deflation

Nearly all economists agree deflation is at
least as bad as inflation





With deflation, greater defaults on loans
Greater bank failure
Capital cannot be channeled to good investments
Real output declines
May have long run effects
Growing the Money Supply

Both Keynsians and Monetariasts:


Keynsian (activist)


Err on the side of inflation
Time monetary policy to stabilize prices and output
Monetariasts



Grow money supply at a small constant rate.
Result will be moderate inflation from year to year, but
benefit will be somewhat of a hedge against deflation.
Any other efforts to “time” policy will simply result in
greater volatility in output.
Monetariast Critique of Keynes

Government does not always act in our best
interest


Example: Government spending binges bring shortterm gain at cost of high inflation
Government cannot act before prices adjust

Example: Government spending only creates greater
volatility in output
Governments and Self-Interest
P
3.
2.
1.
Aggregate Output, Y
Government spending
shifts demand to right
Governments and Bad Timing
P
1&5
4.
2.
3.
Aggregate Output, Y
Free Markets

Great depression generated distrust of free
markets


Shift to quasi-socialism
In general, the world is learning that free
markets (prices) do a better job allocating
resources than governments.


Deregulation of airline industry in U.S.
Privatization of mining in U.K.
Free Markets

The invisible hand cannot always be left to
work on its own however.



Free-rider problem
Externalities
Adverse selection
Governments & Monetary
Policy

Because of adverse selection, governments should
take the role of printing money.

Some kind of policy is needed.
1)
Gold Standard
2)
Passive (Monetariast) policy
Friedman: grow money supply at constant rate
3)
Activist (Keynsian) monetary policy
Time money supply to control inflation and minimize
fluctuations in output
Gold Standard

Governments print money backed by gold

Money supply is affected by supply of gold


Governments lose control over monetary policy –
Government is subject to temptation to print more
currency than it has in gold reserves.


Leads to “runs on the central bank” and currency
devaluation.
If government can be “trusted”, at least a passive monetary
should be preferred
Effective Central Banks

Independence from political pressure



Decision making by committee


Control over own budgets
Policies must be irreversible
Risk of putting one person in charge can be high
Accountability and Transparency


Establish a system of goals
Publicly report progress
Passive Policy

Why not just passively grow the money supply at a constant
rate?

Could potentially lead to greater price stability than gold
standard.

Money supply is measurable, and the central bank could be held
accountable for its actions.

However, the primary goal of monetary policy is to control
inflation.
 The relationship between money supply and inflation is far from
exact.
Money and Inflation
Inflation 2 Years Later
14
12
1960-1980
10
8
1990-2000
6
4
2
0
0
2
4
6
8
Money Growth
10
M2 Growth Rate and CPI Inflation Rate 2 years later.
12
14
Current Approach

Congressional legislation dictates Fed to
actively determine monetary policy to achieve




maximum employment
stable prices
moderate long-term interest rates
How do we know it works?

Monetariasts: active policies may simply add to
volatility of output and prices
Equilibrium

Keynsians:




Wages are sticky.
Short-run aggregate supply is slow to shift,
particularly when unemployment is high.
Government is needed to restore economy to
equilibrium.
Monetariasts:


Wages are not sticky
Best thing to do is to leave economy alone
Case 1: SRS Shifts Left

Consider a natural disaster that destroys oil
refineries.

Cost of oil increases.

This causes the SRS curve to shift left

Result:


Lower output
Higher prices (inflation)
Case 1: SRS Shifts Left
P
2.
1.
Aggregate Output, Y
Case 1: Keynsian View

Wages are slow to adjust, so the economy can stay
out of equilibrium for several years.



This is believed to be particularly true when the labor
market is slack
Unions, for example, prevent employers from lowering
wages
Increased money supply can increase aggregate
demand.


Lower unemployment (higher output) at the cost of inflation.
Keynsian view: benefit outweighs costs
Case 1: Keynsian View of
Government Action
P
3.
2.
1.
Aggregate Output, Y
Case 1: Monetariast View

Wages adjust rather quickly – at least faster
than the government has time to act.

Correct action is to let the economy alone.

If government acts:


Increased volatility of output and prices
Inflation
Case 1: Monetariast View of
Government Action
P
5.
4.
2.
1&3.
Aggregate Output, Y
Case 1: Monetariast View of No
Government Action
P
2.
1&3
Aggregate Output, Y
Non-activist Argument

Data Lag – it takes time for policy makers to obtain
the data that tell them what’s going on.


Recognition lag – it takes time for policy makers to
realize what the data is saying about the future.


Data on quarterly GDP not available for several months until
after the quarter.
NBER won’t classify the economy in a recession until 6
months after it determines one might have begun.
Effectiveness lag – Once money supply has
changed, it can take time for effects to be carried out
Case 2: AD Shifts Left

Keynsians: AD curve shifts left with



Monetariasts: AD curve shifts left with


Decrease in money supply (bank failures)
Irrational pessimism by consumers
Decrease in money supply (bank failures)
Result:


Lower output
Lower prices (deflation)
Case 2: AD Shifts Left
P
2.
1.
Aggregate Output, Y
Case 2: Keynsian View

Wages are slow to adjust, so the economy can stay
out of equilibrium for several years.



This is believed to be particularly true when the labor
market is slack
Unions, for example, prevent employers from lowering
wages
Increased money supply can increase aggregate
demand.


Lower unemployment (higher output)
Prices restored to original level
Case 2: Keynsian View of
Government Action
P
1&3
2.
Aggregate Output, Y
Case 2: Monetariast View

Wages adjust rather quickly – at least faster
than the government has time to act.

Correct action is to let the economy alone.

If government acts:


Increased volatility of output and prices
Inflation
Case 2: Monetariast View of
Government Action
P
1&5
4.
2.
3.
Aggregate Output, Y
Case 2: Monetariast View of No
Government Action
P
1.
2.
3.
Aggregate Output, Y
Case 3: AD Shifts Right

Keynsians: AD curve shifts right with



Monetariasts: AD curve shifts right with


Increase in money supply (loose credit)
Irrational exuberance by consumers
Increase in money supply (loose credit)
Result:


Tight labor market
Higher prices (inflation)
Case 3: AD Shifts Right
P
2.
1.
Aggregate Output, Y
Case 3: Keynsian View



Wages are slow to adjust
When they do, result will be high inflation
Decreased money supply can decrease
aggregate demand.


Output restored to equilibrium
Prices restored to original level
Case 3: Keynsian View of
Government Action
P
2.
1&3
Aggregate Output, Y
Case 3: Monetariast View

Wages adjust rather quickly – at least faster
than the government has time to act.

Correct action is to let the economy alone.

If government acts:


Increased volatility of output and prices
Deflation
Case 3: Monetariast View of
Government Action
P
3.
2.
4.
1&5
Aggregate Output, Y
Case 3: Monetariast View of No
Government Action
P
3.
2.
1
Aggregate Output, Y
Successful Active Monetary
Policy

New Zealand

Canada

United Kingdom

United States