1 / 17

Monetary Theory:

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.

chantale-scott
Download Presentation

Monetary Theory:

An Image/Link below is provided (as is) to download presentation Download Policy: Content on the Website is provided to you AS IS for your information and personal use and may not be sold / licensed / shared on other websites without getting consent from its author. Content is provided to you AS IS for your information and personal use only. Download presentation by click this link. While downloading, if for some reason you are not able to download a presentation, the publisher may have deleted the file from their server. During download, if you can't get a presentation, the file might be deleted by the publisher.

E N D

Presentation Transcript

  1. Monetary Theory: The AD/AS Model – Pt. II ECO 473 – Money & Banking – Dr. D. Foster

  2. 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

  3. 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.

  4. The Money Supply and the Long Run Equilibrium between Aggregate Demand and Aggregate Supply P There is a “long run” Aggregate Supply,which is perfectly verticalat the “full employment”level of Real GDP. ASLR It is unaffected by changes in the price level, but is affected by a host of real variables… P1 Classical Model of the Economy AD1 Q or R-GDP

  5. 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%…

  6. Short Run Aggregate Supply • 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. • What about: • Sticky prices • Misperception • Intertemporal substitution Unnecessary complicationsto explain the SR AS.Inflexible wages is all we need. What happens if there is a AD?

  7. From SR to LR Aggregate Supply An increase in AD triggers events. AS3 P ASLR AS2 AS1 Prices rise, wages lag, output rises. Eventually, wages catch up and AS declines. In LR, onlyprices rise. P3 P2 P1 AD2 AD1 Q or R-GDP Q2 Q*

  8. AS/AD Model – Hints at 4 types of changes P ASLR • 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) AS1 P1 AD1 Q or R-GDP Q*

  9. Are Monetary Policies Effective? • In the Short Run: • If they are unexpected. • If wage/price rigidities persist. • Over time, these should be less likely. • How are expectations formed? • Adaptively. • Rationally.

  10. Velocity of M1, M2 and MZM, 1960-2013

  11. Persistent inflation & inflationary expectations AS5 The Fed tries to reduce unemployment and increase output by MS. This AD. AS4 AS3 P AS2 AS1 With a lag, the AS will decrease so all we see is P. P3 The Fed keeps trying, but now no lag in AS. If the Fed stops inflationary expectations will continue to AS, now Q. P1 P2 P4 AD2 AD2 AD1 Q or R-GDP Q*

  12. Monetarist vs. Keynesian • How fast can the economy recover from recession? • very fast not very fast • G source of disruption Mkt. source of disruption • What are the initial causes of a recession? • MS Investment • Fed as source Lack of “animal spirits” • Should the gov’t aid in the recover from recession? • No, use rule Yes, use discretion • Favor monetary policy Favor fiscal policy • What is the effect of raising G and raising T? • G dubious effectsG is the key to success • T slows economic growth T is easily offset by G

  13. Monetarist vs. Keynesian Short Run Aggregate Supply The AS is flat in the Keynesian view and steep according to the Monetarists. P ASLR AS - Monetarist AS - Keynes So, a decrease in the AD will have different consequences in the two theories. P1 AD1 AD2 Q or R-GDP Q*

  14. Other observations on the Business Cycle • 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.

  15. Other observations on the Business Cycle • 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.

  16. Current Problems & Policy Questions • Decreased AD sends us into recession. Prices ASLR ASSR • Fed expands the MS to stimulate economic growth. Doesn’t work. P3 AD’’’ • Eventually, there’s an overreaction. P1 AD P2 • Sharply rising AD leads to high levels of inflation. AD’’ AD’ What will be the effect of the Fed’s having MB to $4 tr and TR to $2.6 tr? Q’ Q = Real GDP Q*

  17. Monetary Theory: The AD/AS Model – Pt. II ECO 473 – Money & Banking – Dr. D. Foster

More Related