Transcript Ch 17: Monetary Theory I

Why Was Unemployment So High for So Long?
“The Great Recession” lasted December 2007 - July 2009. Yet, unemployment in
November 2012 remained at 7.7%.
Many think fin crisis led to higher cyclical & structural unemployment causing higher
“new normal” natural rate of unemployment. Disagreement about why it is so high.
Some believed aggregate demand was insufficient & asked for conventional policies.
Others saw problems with aggregate supply, because of increased econ uncertainty
or mismatched employers’ needs (manufacturing & oil industry) & labor supply
(construction, automobile & related industries) especially in different geographical
regions, exuberated by labor immobility (w/ 20% lower real-estate prices many houses
worth < mortgages, prevent people from selling houses & moving).
Macroecon models analyze business cycles. Monetary theory links money supply &
interest rates w/ RGDP & inflation.
Aggregate demand & aggregate supply model captures basic ideas developed by
Keynes in 1930s following great depression.
The Aggregate Demand Curve
Relationship between aggregate expenditures (AE = C + I + G + NX) & prices
C = spending by households on goods & services for consumption
I = planned spending by firms on capital goods, and by households on new homes
G = government purchases of goods & services (excluding transfer payments, e.g. SS)
NX = Net exports
AD is downward sloping because
inflation ↓ real money balances (M/P)
=> ↑ interest % => ↓ C, I & NX.
The Market for Money and the Aggregate Demand Curve
Analysis of market for money: M1 demand (households & firms, primarily determined by
transactions motive - hold money as medium of exchange) = MD interaction w/ M1
supply (Fed) = MS or liquidity preference theory (coined by John Maynard Keynes).
Real money balances: value of $ held by households & firms adjusted for inflation.
Trade-off: Households & firms holding money lose more when short term interest %
(opportunity cost of holding money) ↑.
Inflation causes supply
curve for real balances
to shift left (M/P)S→(M/P)S2
=> interest % ↑.
Shifts of the Aggregate Demand Curve (recall AE = C + I + G + NX)
The Aggregate Supply Curve
Total quantity of output (GDP) firms are willing to supply at a given price level.
Short-run aggregate supply (SRAS) curve: price vs aggregate output supplied.
SRAS slopes upward like individual firm’s supply curve but it represents ≠ behavior.
Alternative explanation for why SRAS slops upward:
New classical view (misperception theory) hard for firms to distinguish ↑ in relative P
of their products against other products vs ↑ in all P or inflation.
If your relative P ↑, demand for your products ↑ => ↑ production leads to ↑ profit.
If all prices ↑ when relative prices unchanged => ↑ production doesn’t ↑ profit.
If firms mistook inflation (= relative P) for relative price ↑ => aggregate output ↑.
New classical view: Y = YP + a(P - Pe) => if P = Pe then Y = YP & if P </> Pe then Y ↓/↑.
Keynesian view inflation ↑ output but keeps short run input P sticky (adjust slowly to
changes in AD) => inflation ↑ firms’ demand & ↑ production ↑ profits.
The most extreme view, SRAS horizontal: firms adjust Y to AD changes w/o changing P.
Contemporary Keynes’s followers (new Keynesian view) explain short run sticky P using
real-world market characteristics: rigid long-run contracts & monopolistically competitive
markets (downward sloping IDC => P ≠ slowly due to costs of P change in catalogs &
store shelves, w/o firm w/ higher P losing entire demand as in perfect competition).
The Long-Run Aggregate Supply (LRAS) Curve
Long run relationship between P & aggregate output supplied by firms, vertical at YP.
Keynesian view (sticky short run input P): inflation > % ↑ input P => ↑ profit from ↑ Y.
Over time input P ↑ in line w/ inflation, so firms adjust P to long run demand change.
As with the new classical view, the LRAS curve is vertical at potential GDP, or Y = YP.
Variables That Shift the Short-Run & Long-Run Aggregate Supply Curves
Short-Run & Long-Run Equilibrium in AD & AS Model
Short-Run Equilibrium
Short-run equilibrium E1 where
AD intersect SRAS.
Higher/lower prices associated w/
excess supply/demand of output.
Long-Run Equilibrium
↑ in AD shifts AD1→AD2, ↑ Y & P to short run eql E2.
Because Y2 > YP, P ↑, shifting SRAS1→SRAS2
to long run equilibrium E3, w/ Y = YP, but ↑ P2.
W/ vertical LRAS AD shocks affect P but not Y.
Monetary neutrality: money supply affects prices
but not output in the long run.
Economic Fluctuations in the United States
AD Shocks (1964-1969) : Fed concerned that AD ↑ due to government purchases
during Vietnam War would ↑ money demand & interest % used expansionary monetary
policy to maintain interest %. AD-AS model predicts Y ↑ & inflation due to fiscal &
monetary expansion over several years, as it happened in real life.
AS Shocks (1973-75 & after 1995): Two negative AS shocks (1970s oil embargo &
world bust harvests) shift SRAS left causing stagflation (↑ P & ↓ Y).
Positive supply shock (↑ US productivity 1990s-00s) shift SRAS right => ↓ P & ↑ Y.
Credit Crunch & AD (1990–91): stringent bank regulation & real estate P ↓ combined
w/ lack of funds from other sources ↓ consumption shift AD left => ↓ P & ↓ Y.
Over time lower AD puts downward pressure on P & shifts SRAS right.
Investment & Brief 2001 Recession: Heavy IT investments in late 1990s. Capital over
accumulated when expected future profitability ↓ after 2000 .com bust. ↓ investments
shift AD left =>↓ P & ↓ Y (cushioned by SRAS & LRAS right shift due to ↑ productivity).
Are Investment Incentives Inflationary? In AD-AS model investment ↑ shift AD right.
However, capital investment also ↑ econ’s capacity shifting SRAS & LRAS right ↓
inflationary pressure. Evidence suggests substantial AS response limiting inflation.
The Effects of Monetary Policy
Business cycle is alternating periods of econ expansion & economic recession.
Stabilization monetary or fiscal policy ↓ business cycle severity and stabilizes econ.
AD shock: AD curve shift left to AD2, Y ↓ to Y2. Fed expansionary monetary policy shifts
& recession at E2. Over time SRAS shit right AD back to AD1 & full employment eql E1.
Relative to nonintervention case, econ
restoring full employment equilibrium at E3.
recovers quicker but at ↑ long-run P.
Dealing with Shocks to Aggregate Demand & Aggregate Supply
Econ in equilibrium at full employment simultaneously hit w/ negative AD & AS shocks.
AD-AS graph of short-run
equilibrium after the shocks.
We know that Y2 ↓ but what
happens w/ P2 depends on
how much AD & AS shift left.
If Fed doesn’t intervene, w/
Y2 < YP over time P & input
costs ↓ shifting SRAS right
adjusting econ back to
long-run eql at lower P3.
Fed expansionary policy
shifts AD right adjusting
econ back to long-run
equilibrium at higher P3.
Was Monetary Policy Ineffective during the 2007–2009 Recession?
Do high US unemployment & modes RGDP ↑ indicate failed monetary policy?
Fed unable to pull off rapid & smooth return to full employment but fin crises caused
recessions are almost always very severe.
2007-09 recession wasn’t temporary AD ↓ but due to structural, perhaps permanent,
changes in the economy.
Some believe that large AD ↓ reduce YP in a process known as hysteresis.
Persistently high unemployment in many European countries during the 1980s and
1990s may reflect hysteresis.
Government policies (e.g., generous unemployment benefits, high tax rates, and
hiring & firing restrictions) may also help explain sluggish employment growth.
Fed Chairman Bernanke referred to problems with AS as the “unusual uncertainty.”
Conventional expansionary monetary policy would be effective only if the main
problem facing the economy was insufficient AD.
Since the economy was sailing in largely uncharted waters, it was unclear whether
AD or AS was the bigger problem.