Download AS/AD Model part 2

Monetary Theory:
The AD/AS Model – Pt. II
ECO 473 – Money & Banking – Dr. D. Foster
Warning .. Warning .. Warning
• Aggregate Supply and Aggregate Demand are not
like market supply & demand !!!!!
• The “static” analysis only hints at dynamic
interpretation.
• Ceteris Paribus assumption problematic to the point
of being wholly inappropriate.
Contrasting views:
Classical/Monetarist vs. Keynesian
Friedman vs. Keynes
Non-activist vs. Activist
Aggregate Demand
• The price level and real output demanded are
inversely related.
• A fall in the price level will increase quantity
demanded.
Aggregate Supply
• In the long run it is fixed at the level of the full
employment of resources.
• A change in the price level will not affect AS-LR.
The Money Supply and the Long Run Equilibrium
between Aggregate Demand and Aggregate Supply
P
ASLR
P1
There is a “long run”
Aggregate Supply,
which is perfectly vertical
at the “full employment”
level of Real GDP.
It is unaffected by changes in
the price level, but is affected
by a host of real variables…
AD1
Classical Model
of the Economy
Q or R-GDP
Short Run Aggregate Supply – Wage Inflexibility
• Nominal wages are sluggish upwards:
 A rise in prices has delayed effect on wages.
• Nominal wages are inflexible downwards:
 A fall in prices will result in employment and y.
• Workers have money illusion:
 Higher nominal wages are viewed as real wage.
 So, more workers available even though real wage
has not risen.

e.g. if prices rise 5% and wages rise 3%…
Short Run Aggregate Supply
• What about:
 Sticky prices
 Misperception
 Intertemporal substitution
Unnecessary complications
to explain the SR AS.
Inflexible wages is all we need.
What happens if there is a AD?
• The Short Run will adjust to the Long Run:
 An AD will P and Q, but only in the SR.
 Prices rise but wages lag. Firms employment and
output.
 Eventually, workers realize their real wages (W/P) are
falling, get comparable wage, AS.

The temporary profit motive has been eliminated.
From SR to LR Aggregate Supply
P
ASLR
AS3
An increase
in AD triggers
events.
AS2
AS1
Prices rise,
wages lag,
output rises.
P3
Eventually,
wages catch up
and AS declines.
P2
P1
AD2
AD1
Q*
Q2
Q or R-GDP
In LR, only
prices rise.
AS/AD Model – Hints at 4 types of changes
P
ASLR
AS1
• Inflation with growth due
to rising AD.
• Depression with deflation
due to falling AD.
• Growth with deflation due
to rising AS.
• Depression with inflation
due to falling AS.
(stagflation)
P1
AD1
Q*
Q or R-GDP
The Transmission Mechanism of Monetary Policy
• Fed buys bonds.
• Bank reserves rise, as do their excess reserves.
• The money supply expands.
• Interest rates fall to equate MS with MD.
• Investment spending rises.
• Income rises.
And, if the Fed
sells bonds …
The Transmission Mechanism of Monetary Policy
• Assume:
• money multiplier is 2.5
• interest rates change by 1% per $80b ΔMS
• investment changes by $35b per 1% Δr
• income rises $5 for each $1 increase in spending
How much will income change by if the Fed buys
$10 billion worth of bonds?
How much will income change by if the Fed sells
$15 billion worth of bonds?
Are Monetary Policies Effective?
• In the Short Run only:
 If they are unexpected.
 If wage/price rigidities persist.
 Over time, these should be less likely.
• How effective?
 The liquidity effect – How responsive are interest rates
to changes in the money supply? [∆i is 3% …]
 The interest elasticity of investment –
How responsive is investment to a change
in interest rates? [∆I is $50 b. …]
Velocity of M1: 1970 - 2015
Velocity of M2: 1970 - 2015
Velocity of MZM: 1970 - 2015
Monetarist
vs.
Keynesian
What are the initial causes of a recession?
Money Supply
The Fed as source.
Investment
Lack of “animal spirits.”
How fast can the economy recover?
Very fast.
Not very fast.
Gov’t as source of disruption.
Market instability.
Markets are quite robust.
May have long-term
unemployment problem.
How does monetary policy help?
It has a direct effect on
consumer spending.
Works through effects on
investment spending.
Very powerful.
Likely ineffective.
“Pushing on a string.”
Monetarist
vs.
Keynesian
Should the government aid in the
recovery from recession?
No.
Yes.
Use rules.
Use discretion.
Monetary rules will provide
the necessary effect.
Fiscal policies, especially
gov’t spending are best.
What about increase both government
spending and taxes, to maintain
a balanced budget?
Government spending
has dubious effects.
Taxes will slow down
economic growth.
Government spending is
the key to success.
Taxes will be more than
offset by gov’t spending.
Keynesian vs. Monetarist Short Run Aggregate Supply
P
ASLR
AS - Monetarist
The AS is flat in
the Keynesian
view and steep
according to the
Monetarists.
AS - Keynes
P1
AD1
So, a decrease in
the AD will have
different
consequences in
the two theories.
AD2
Q*
Q or R-GDP
Persistent inflation & inflationary expectations
P
AS4
AS5
AS3
AS2
AS1
P4
P3
P2
P1
The Fed tries to
reduce unemployment
and increase output by
MS. This AD.
With a lag, the AS
will decrease so all
we see is P.
The Fed keeps trying,
but now no lag in AS.
AD2
AD2
AD1
Q*
Q or R-GDP
If the Fed stops
inflationary
expectations
will continue to
AS, now Q.
Can we eliminate inflation by AS (short run)?
 No, these policies are “doomed to failure.”
Remember, inflation is a monetary phenomenon,
and caused by shifts in the AD.
•
So, what are these policies?
• Wage & price controls
• Tax-based Incomes policies (TIPs)
• Supply-side incentives to boost output.
• Remove barriers that keep wages/prices from falling.
To eliminate inflation we must AD
 But, we’ll have to contend with inflationary expectations.
How?
• Gradualism approach
• Going cold turkey
• Indexing
• Wages, mortgage interest rates, taxes …
 And, what of the role of government?
Increasing share of GDP & growth is slower, recoveries
taking longer. Benefits of G may not be worth the costs.
Current Problems & Policy Questions
Prices
• Decreased AD sends
us into recession.
ASLR
ASSR
• Fed expands the MS
to stimulate economic
growth. Doesn’t work.
P3
AD’’’
P1
• Eventually, there’s an
overreaction.
AD
P2
AD’’
AD’
Q’
Q*
Q = Real GDP
• Sharply rising AD
leads to high levels of
inflation.
What will be the
effect of the Fed’s
having MB to $4 tr
and TR to $2.6 tr?
Monetary Theory:
The AD/AS Model – Pt. II
ECO 473 – Money & Banking – Dr. D. Foster