Download Monetary Theory I

R. GLENN
HUBBARD
ANTHONY PATRICK
O’BRIEN
Money,
Banking, and
the Financial
System
© 2012 Pearson Education, Inc. Publishing as Prentice Hall
CHAPTER
17
Monetary Theory I: The
Aggregate Demand and
Aggregate Supply Model
LEARNING OBJECTIVES
After studying this chapter, you should be able to:
17.1
Explain how the aggregate demand curve is derived
17.2
Explain how the aggregate supply curve is derived
17.3
Demonstrate macroeconomic equilibrium using the aggregate demand and
aggregate supply model
17.4
Use the aggregate demand and aggregate supply model to show the effects of
monetary policy
© 2012 Pearson Education, Inc. Publishing as Prentice Hall
CHAPTER
17
Monetary Theory I: The
Aggregate Demand and
Aggregate Supply Model
IS THE UNITED STATES FACING A “NEW NORMAL” OF HIGHER
UNEMPLOYMENT?
•“The Great Recession” began in December 2007 and ended in July 2009. Yet,
the unemployment rate actually increased after the end of the recession.
•Economic growth is not predicted to be fast enough to bring these high
unemployment rates down any time soon. Economists have begun speaking of
the “new normal,” in which unemployment rates might be stuck at higher levels
for many years.
•Adjusting to structural changes in the economy may take considerable time.
•Read AN INSIDE LOOK AT POLICY on page 538 for a discussion of Fed’s
forecasts of future unemployment.
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Key Issue and Question
Issue: During the recovery from the financial crisis, the unemployment
rate remained stubbornly high.
Question: What explains the high unemployment rates during the
economic expansion that began in 2009?
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17.1 Learning Objective
Explain how the aggregate demand curve is derived.
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Figure 17.1
The Aggregate Demand
Curve
The aggregate demand, AD,
curve shows the relationship
between the price level and
the level of aggregate
expenditure.•
The Aggregate Demand Curve
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The Market for Money and the Aggregate Demand Curve
The market for money involves the interaction between the demand for M1—
currency plus checkable deposits—by households and firms and the supply of
M1, as determined by the Federal Reserve.
The analysis of the market for money is sometimes referred to as the liquidity
preference theory, a term coined by the British economist John Maynard Keynes.
Real money balances The value of money held by households and firms,
adjusted for changes in the price level; M/P.
The primary reason households and firms demand money is called the
transactions motive—to hold money as a medium of exchange.
Households and firms face a trade-off. The higher the interest rate on short-term
assets such as Treasury bills, the more households and firms give up when they
hold large money balances. So, the short-term nominal interest rate is the
opportunity cost of holding money.
The Aggregate Demand Curve
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Figure 17.2
The Market for Money
In panel (a), the demand for real balances is downward sloping because higher short-term
interest rates increase the opportunity cost of holding money.
The supply of real balances is a vertical line because we assume for simplicity that the
Fed can control perfectly the level of M1.
In panel (b),we show that an increase in the price level causes the supply curve for real
balances to shift from (M/P)1S to (M/P)S2 , thereby increasing the equilibrium interest rate
from i1 to i2.•
The Aggregate Demand Curve
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Shifts of the Aggregate Demand Curve
Table 17.1
Determinants of Shifts in the Aggregate Demand Curve
The Aggregate Demand Curve
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Shifts of the Aggregate Demand Curve
Table 17.1
Determinants of Shifts in the Aggregate Demand Curve (continued)
The Aggregate Demand Curve
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17.2 Learning Objective
Explain how the aggregate supply curve is derived.
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Aggregate supply The total quantity of output, or GDP, that firms are willing to
supply at a given price level.
Short-run aggregate supply (SRAS) curve A curve that shows the
relationship in the short run between the price level and the quantity of
aggregate output, or real GDP, supplied by firms.
Though the short-run aggregate supply curve slopes upward like the supply
curve facing an individual firm, it represents different behavior.
Next we examine the new classical and new Keynesian views that attempt to
explain why the SRAS curve slopes upward.
The Aggregate Supply Curve
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The Short-Run Aggregate Supply (SRAS) Curve
The Aggregate Supply Curve
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An alternative explanation for why the SRAS curve is upward sloping comes
from the argument of John Maynard Keynes and his followers that prices adjust
slowly in the short run in response to changes in aggregate demand. That is,
prices are sticky in the short run.
In the most extreme view of price stickiness, we would observe a horizontal
SRAS curve because prices would not adjust at all to increases or decreases in
aggregate demand. Rather, firms would adjust their production levels to meet
the new level of demand without changing their prices.
Contemporary followers of Keynes’s view have sought reasons for the failure of
prices to adjust in the short run. Economists who embrace the new Keynesian
view use characteristics of many real-world markets—rigidity of long-term
contracts and imperfect competition—to explain price behavior.
New Keynesian economists argue that prices will adjust only gradually in
monopolistically competitive markets when there are costs to changing prices.
The costs of changing prices are sometimes called menu costs.
The Aggregate Supply Curve
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The Long-Run Aggregate Supply (LRAS) Curve
Long-run aggregate supply (LRAS) curve A curve that shows the
relationship in the long run between the price level and the quantity of
aggregate output, or real GDP, supplied by firms.
The long-run aggregate supply (LRAS) curve is vertical at YP.
In the new Keynesian view, in the short run many input costs are fixed, so firms
can expand output without experiencing an increase in input cost that is
proportional to the increase in the prices of their products. Over time, though,
input costs increase in line with the price level, so both firms with flexible prices
and firms with sticky prices adjust their prices in response to a change in
demand in the long run. As with the new classical view, the LRAS curve is
vertical at potential GDP, or Y = YP.
The Aggregate Supply Curve
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Figure 17.3
The Short-Run and LongRun Aggregate Supply
Curves
The SRAS curve is upward
sloping: When the price level
P exceeds the expected price
level Pe, the quantity of
output supplied rises.
In the long run, the actual and
expected price levels are the
same. Therefore, the LRAS
curve is vertical at potential
GDP,YP.
The Aggregate Supply Curve
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Making the Connection
Shock Therapy and Aggregate Supply in Poland
In the early 1990s, the former Communist countries in Eastern Europe were
trying to reform their economies.
To transform its centrally planned economy and remove price controls, Poland
chose shock therapy—pursuing radical reforms but much more rapidly than
other countries.
The immediate result was a rise in the price level and a decline in output. But
Polish policymakers were more interested in the long-run prospects for
economic growth than in the short-run changes in output.
The gamble in Poland was that these short-term costs would be rewarded
handsomely in long-term gains in production and consumption possibilities for
Polish citizens.
Many economists, notably Jeffrey Sachs of Columbia University, argued that
the rebound of the Polish economy in 1992 was the beginning of favorable
shifts in long-run aggregate supply in Poland. The removal of central planning
and improvements in factory productivity shifted the LRAS curve to the right,
increasing output and dampening inflationary pressures.
The Effects of Monetary Policy
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Shifts in the Short-Run Aggregate Supply (SRAS) Curve
Supply shock An unexpected change in production costs or in technology that
causes the short-run aggregate supply curve to shift.
There are three main factors that cause the short-run aggregate supply curve
to shift:
1. Changes in labor costs.
2. Changes in other input costs.
3. Changes in the expected price level.
Shifts in the Long-Run Aggregate Supply (LRAS) Curve
The LRAS curve shifts over time to reflect growth in the potential level of
output. Sources of this economic growth include (1) increases in capital and
labor inputs and (2) increases in productivity growth (output produced per unit
of input).
The Aggregate Supply Curve
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Table 17.2
Determinants of Shifts in the Short-Run and Long-Run Aggregate Supply Curves
The Aggregate Supply Curve
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Table 17-2
(continued)
Determinants of Shifts in the Short-Run and Long-Run Aggregate Supply Curves
The Aggregate Supply Curve
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17.3 Learning Objective
Demonstrate macroeconomic equilibrium using the aggregate demand and
aggregate supply model.
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Short-Run Equilibrium
Figure 17.4
Short-Run Equilibrium
The economy’s short-run
equilibrium is represented by
the intersection of the AD and
SRAS curves at E1. The
equilibrium price level is P1.
Higher price levels are
associated with an excess
supply of output (at point A),
and lower price levels are
associated with excess
demand for output (at point
B).
Equilibrium in the Aggregate Demand and Aggregate Supply Model
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Long-Run Equilibrium
Figure 17.5
Adjustment to Long-Run
Equilibrium
From an initial equilibrium at E1, an
increase in aggregate demand shifts
the AD curve from AD1 to AD2,
increasing output from YP to Y2.
Because Y is greater than YP, prices
rise, shifting the SRAS curve from
SRAS1 to SRAS2.
The economy’s new equilibrium is at
E3. Output has returned to YP, but
the price level has risen to P2.
The LRAS curve is vertical at YP,
potential GDP. Shifts in the AD curve
affect the level of output only in the
short run. This outcome holds in both
the new classical and new
Keynesian views, although price
adjustment is more rapid in the new
classical view.
Equilibrium in the Aggregate Demand and Aggregate Supply Model
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Because the LRAS curve is vertical, economists generally agree that in the
long run changes in aggregate demand affect the price level but not the output
level.
Monetary neutrality The proposition that changes in the money supply have
no effect on output in the long run because an increase (decrease) in the
money supply raises (lowers) the price level in the long run but does not
change the equilibrium level of output.
Equilibrium in the Aggregate Demand and Aggregate Supply Model
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Economic Fluctuations in the United States
Shocks to Aggregate Demand, 1964–1969 During the Vietnam War, the Fed
was concerned that the rise in aggregate demand caused by increases in
government purchases would increase money demand and the interest rate. To
avoid an increase in the interest rate, the Fed pursued an expansionary
monetary policy. Because fiscal and monetary expansion continued for several
years, AD–AS analysis indicates that output growth and inflation should have
risen from 1964 through 1969, and, in fact, that is what happened.
Supply Shocks, 1973–1975 and after 1995 The early 1970s was a period of
rising inflation and falling output, stagflation, as a result of two negative supply
shocks: a sharp reduction in the supply of oil and poor crop harvests around
the world. The negative supply shocks shift the short-run aggregate supply
curve to the left, raising the price level and reducing output. A similar pattern
occurred as a result of negative supply shocks caused by rising oil prices in the
1978–1980 period. In the late 1990s and 2000s, the U.S. economy experienced
favorable supply shocks, such as the acceleration in productivity growth.
Equilibrium in the Aggregate Demand and Aggregate Supply Model
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Credit Crunch and Aggregate Demand, 1990–1991 A credit crunch was the
result of stringent bank regulation and declines in real estate values. Because
households and businesses weren’t able to replace bank credit with funds from
other sources, consumer spending fell. In AD–AS analysis, the decline in
spending reduces aggregate demand and puts downward pressure on prices,
shifting the SRAS curve down. In fact, output growth fell during the 1990–1991
recession and inflation declined from 4.3% in 1989 to 2.9% in 1992.
Investment and the 2001 Recession The brief recession of 2001 began as a
result of a decline in business investment. In the late 1990s, many firms
invested heavily in information technology. The U.S. economy accumulated
more capital than businesses desired when expectations of future profitability
declined after 2000. In AD–AS analysis, the decline in planned investment
shifts the AD curve to the left, reducing both output growth and inflation. Fastpaced productivity growth during this period led to a rightward shift of the SRAS
and LRAS curves and cushioned the decline in output.
Equilibrium in the Aggregate Demand and Aggregate Supply Model
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Are Investment Incentives Inflationary? In the late 1990s, many economists
and policymakers urged consideration of tax reforms that would stimulate
business investment, such as expensing—writing off new plant and equipment
purchases at once instead of gradually—and reducing the cost of capital
through cuts in dividend and capital gains taxes.
Many economists argued that such reforms would increase investment demand
and output of capital goods. Would they also increase inflation?
In AD–AS analysis, the stimulus to investment translates into an increase in
aggregate demand, shifting the AD curve to the right.
However, as the new plant and equipment are installed, the economy’s
capacity to produce increases, and the SRAS and LRAS curves shift to the
right, reducing the inflationary pressure from pro-investment tax reform.
Recent evidence suggests that the supply response is substantial and
investment incentives are unlikely to be inflationary.
Equilibrium in the Aggregate Demand and Aggregate Supply Model
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17.4 Learning Objective
Use the aggregate demand and aggregate supply model to show the effects of
monetary policy.
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Business cycle Alternating periods of economic expansion and economic
recession.
Stabilization policy A monetary policy or fiscal policy intended to reduce the
severity of the business cycle and stabilize the economy.
The Effects of Monetary Policy
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An Expansionary Monetary Policy
Figure 17.6 (1 of 2)
Effects of Monetary Policy
Panel (a) shows that from
an initial full-employment
equilibrium at E1, an
aggregate demand shock
shifts the AD curve from
AD1 to AD2, and output
falls from YP to Y2.
At E2, the economy is in a
recession.
Over time, the price level
adjusts downward,
restoring the economy’s
full employment
equilibrium at E3.
The Effects of Monetary Policy
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An Expansionary Monetary Policy
Figure 17.6 (2 of 2)
The Effects of Monetary Policy
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Effects of Monetary Policy
Panel (b) shows that from
an initial full-employment
equilibrium at E1, an
aggregate demand shock
shifts the AD curve from
AD1 to AD2.
At E2, the economy is in a
recession.
The Fed speeds recovery,
using an expansionary
monetary policy, which
shifts the AD curve back
from AD2 to AD1.
Relative to the
nonintervention case, the
economy recovers more
quickly back to full
employment, but with a
higher long-run price
level.•
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Solved Problem
17.4
Dealing with Shocks to Aggregate Demand and Aggregate Supply
Assume that the economy is initially in equilibrium at full employment. Then
suppose that the economy is hit simultaneously with negative aggregate
demand and aggregate supply shocks: There is a large increase in oil prices
and a sharp decline in consumption spending as households become
pessimistic about their future incomes.
a. Draw an aggregate demand and aggregate supply graph to illustrate the
initial equilibrium and the short-run equilibrium after the shocks. Do we know
with certainty whether the price level will be higher or lower in the new
equilibrium?
b. Suppose that the Fed decides not to intervene with an expansionary
monetary policy. Show how the economy will adjust back to its long-run
equilibrium.
c. Now suppose that the Fed decides to intervene with an expansionary
monetary policy. If the Fed’s policy is successful, show how the economy
adjusts back to its long-run equilibrium.
The Effects of Monetary Policy
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Solved Problem
17.4
Dealing with Shocks to Aggregate Demand and Aggregate Supply
Step 1 Review the chapter material.
Step 2 Answer part (a) by drawing the appropriate graph and explaining whether
we know whether the price level will rise or fall.
The Effects of Monetary Policy
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Solved Problem
17.4
Dealing with Shocks to Aggregate Demand and Aggregate Supply
Step 3 Answer part (b) by drawing the appropriate graph.
The Effects of Monetary Policy
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Solved Problem
17.4
Dealing with Shocks to Aggregate Demand and Aggregate Supply
Step 4 Answer part (c) by redrawing the appropriate graph.
The Effects of Monetary Policy
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Was Monetary Policy Ineffective during the 2007–2009 Recession?
As we saw in the chapter opener, in late 2010, the U.S. unemployment rate
remained stubbornly high, and increases in real GDP were disappointingly
modest. Do these facts indicate that monetary policy had failed?
Certainly, the Fed was unable to pull off a rapid and smooth return to full
employment of the type illustrated in panel (b) of Figure 17.6.
However, recessions started by financial crises are almost always very severe.
The 2007–2009 recession was not a temporary decline in aggregate demand
but the result of structural, perhaps permanent, changes in the economy.
Unemployed workers might need to be retrained for other jobs or relocate to
find work.
Some economists believe that large negative shifts in aggregate demand
actually reduce the full employment level of output in a process known as
hysteresis.
The Effects of Monetary Policy
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Persistently high rates of unemployment in many European countries during
the 1980s and 1990s may reflect hysteresis.
Government policies, such as generous unemployment insurance benefits,
high tax rates, and hiring and firing restrictions, may also help to explain why
employment growth was sluggish in these countries.
Fed Chairman Ben Bernanke referred to the problems with aggregate supply
as the “unusual uncertainty” in the economic situation. Given that the financial
crisis and recession of 2007–2009 were more severe than any since World War
II, an increased level of uncertainty was unavoidable.
Conventional expansionary monetary policy would be effective only if the main
problem facing the economy was insufficient aggregate demand. Since the
economy was sailing in largely uncharted waters, it was unclear whether
aggregate demand or aggregate supply was the bigger problem.
The Effects of Monetary Policy
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Making the Connection
Is It Like 1939?
Do the events from the Great Depression provide an insight into the recession
of 2007–2009? Was the high unemployment of 1939 due to problems with
aggregate demand or aggregate supply?
Problems with the aggregate supply included substantial increases in tax rates;
a sharp increase in unionization, strikes, and labor unrest; and an apparent
undermining of private property rights.
Hysteresis and “regime uncertainty” are some of the possible explanations for
insufficient aggregate demand.
Undoubtedly, economists will continue to explore the surprising parallels
between the U.S. economy of the 1930s and the U.S. economy following the
beginning of the financial crisis in 2007.
The Effects of Monetary Policy
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Answering the Key Question
At the beginning of this chapter, we asked the question:
“What explains the high unemployment rates during the economic expansion
that began in 2009?”
As we have seen in this chapter, in late 2010, the unemployment rate
remained above 9%, which was unusually high for the post-World War II
period. Economists disagree about why the unemployment rate was so high.
Some economists believed that it was due to insufficient aggregate demand
and suggested that production and employment could be expanded with
conventional macroeconomic stabilization policies. Other economists, though,
saw problems with aggregate supply, either because of potentially long-lived
declines in the importance of residential construction and automobile
industries or because of increased economic uncertainty.
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AN INSIDE LOOK AT POLICY
Unemployment Stays High Despite Low Interest Rates, Fiscal Stimulus
INTERNATIONAL BUSINESS TIMES, Fed Officials See High Unemployment for Years
Key Points in the Article
• Federal Reserve officials acknowledged that unemployment in the United
States would remain high for years. They stressed that the Federal Reserve
would maintain an accommodative monetary policy that had already pumped
more than $1 trillion into the economy.
• Although the financial crisis was subsiding, lending could take years to return
to pre-crisis levels.
• Within the Fed, some of the most contentious debates center around the
outlook for inflation, with some worried about prices rising too fast, and others
worried about disinflation.
• Businesses in the United States are still responding to “replacement demand”
rather than the “expansionary demand” needed to boost economic growth.
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AN INSIDE LOOK AT POLICY
The graph above shows the economy before the recession, in long-run equilibrium at E1
(output = YP, price level = P1).
The recession was caused by a housing and financial crisis, which shifted aggregate
demand from AD1 to AD2.
Eventually, the short-run supply curve could shift from SRAS1 to SRAS2 and the economy
would return to equilibrium at E3, but this could take years, and Fed officials feared that the
disinflation—or deflation—that this requires could lead to another recession.
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