Chapter 26. An Aggregate Supply and Demand Perspective on Money and Economic Stability. Learning Objectives. Introduction

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1 Chapter 26 An Aggregate Supply and Demand Perspective on Money and Economic Stability 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 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

2 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 26-4 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 26-5 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

3 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 26-7 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 26-8 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 Y FE 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

4 FIGURE 26.1 Monetarist response to declines in exogenous investment: Income remains at the full employment level 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 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

5 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 Y FE and P 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, Y FE 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

6 FIGURE 26.2 Keynesian response to declines in exogenous investment: Income falls below full employment level 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 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

7 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 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 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

8 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 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 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

9 Inflation, Money, and the Phillips Curve (Cont.) Figure 26.3 Vertical aggregate supply curve at full employment, Y FE 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 FIGURE 26.3 Anything shifting aggregate demand to the right causes inflation 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

10 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 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 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 Y FE with a lower unemployment rate

11 The graph of a Phillips curve looks like this FIGURE 26.4 Inflation causes higher income (and lower unemployment) with a positively sloped supply curve 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

12 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, Y FE Once these adjustments have been made, the aggregate supply curve becomes vertical and there is no long-run trade-off 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 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

13 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 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 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

14 FIGURE 26.5 Friedman s alleged perverse effects of countercyclical monetary policy 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 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

15 FIGURE 26.6 Aggregate demand and supply shifting together over time according to a fixed monetary rule 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 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