Transcript CHAPTER 26

Chapter 26
An Aggregate
Supply and
Demand
Perspective on
Money and
Economic
Stability
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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
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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
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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
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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
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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
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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
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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
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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
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FIGURE 26.1 Monetarist response to
declines in exogenous investment: Income
remains at the full employment level.
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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
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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
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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
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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
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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
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26-15
FIGURE 26.2 Keynesian response to
declines in exogenous investment: Income
falls below full employment level.
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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
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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
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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
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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
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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
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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
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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
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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
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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
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FIGURE 26.3 Anything shifting aggregate
demand to the right causes inflation
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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
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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
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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
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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
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The graph of a Phillips curve looks
like this
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FIGURE 26.4 Inflation causes higher income
(and lower unemployment) with a positively
sloped supply curve.
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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
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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
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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
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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
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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
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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
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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
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26-39
FIGURE 26.5 Friedman’s alleged perverse
effects of countercyclical monetary policy.
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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
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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
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26-42
FIGURE 26.6 Aggregate demand and supply
shifting together over time according to a fixed
monetary rule.
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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
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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
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26-45