Aggregate D&S II

Economic Spectrum

Money Supply is Important Determinant of Economic Output

Government Spending (Fiscal Policy)is ImportantDeterminant of Economic Output

Free Markets Work

Government Policy Works

Monetariasts

Keynsians

X

Activist (Keynsian)Monetary Policy

Deflation

Nearly all economists agree deflation is at least as bad as inflation With deflation, greater defaults on loans Greater bank failure Capital cannot be channeled to good investments Real output declines May have long run effects

Growing the Money Supply

Both Keynsians and Monetariasts: Err on the side of inflation

Keynsian (activist) Time monetary policy to stabilize prices and output

Monetariasts Grow money supply at a small constant rate. Result will be moderate inflation from year to year, but benefit

will be somewhat of a hedge against deflation. Any other efforts to “time” policy will simply result in greater

volatility in output.

Monetariast Critique of Keynes

Government does not always act in our best interest Example: Government spending binges bring short-

term gain at cost of high inflation

Government cannot act before prices adjust Example: Government spending only creates greater

volatility in output

Governments and Self-Interest

Aggregate Output, Y

P

Government spending shifts demand to right

1.

2.

3.

Governments and Bad Timing

Aggregate Output, Y

P

2.

1&5

3.

4.

Free Markets

Great depression generated distrust of free markets Shift to quasi-socialism

In general, the world is learning that free markets (prices) do a better job allocating resources than governments. Deregulation of airline industry in U.S. Privatization of mining in U.K.

Free Markets

The invisible hand cannot always be left to work on its own however. Free-rider problem Externalities Adverse selection

Governments & Monetary Policy Because of adverse selection, governments should

take the role of printing money.

Some kind of policy is needed.

1) Gold Standard

2) Passive (Monetariast) policyFriedman: grow money supply at constant rate

3) Activist (Keynsian) monetary policyTime money supply to control inflation and minimize fluctuations in output

Gold Standard

Governments print money backed by gold

Money supply is affected by supply of gold Governments lose control over monetary policy –

Government is subject to temptation to print more currency than it has in gold reserves. Leads to “runs on the central bank” and currency

devaluation. If government can be “trusted”, at least a passive monetary

should be preferred

Effective Central Banks

Independence from political pressure Control over own budgets Policies must be irreversible

Decision making by committee Risk of putting one person in charge can be high

Accountability and Transparency Establish a system of goals Publicly report progress

Passive Policy Why not just passively grow the money supply at a constant

rate?

Could potentially lead to greater price stability than gold standard.

Money supply is measurable, and the central bank could be held accountable for its actions.

However, the primary goal of monetary policy is to control inflation. The relationship between money supply and inflation is far from

exact.

Money and Inflation

0

2

4

6

8

10

12

14

0 2 4 6 8 10 12 14Money Growth

Infl

ati

on

2 Y

ea

rs L

ate

r

1990-2000

1960-1980

M2 Growth Rate and CPI Inflation Rate 2 years later.

Current Approach

Congressional legislation dictates Fed to actively determine monetary policy to achieve maximum employment stable prices moderate long-term interest rates

How do we know it works? Monetariasts: active policies may simply add to

volatility of output and prices

Equilibrium

Keynsians: Wages are sticky. Short-run aggregate supply is slow to shift,

particularly when unemployment is high. Government is needed to restore economy to

equilibrium.

Monetariasts: Wages are not sticky Best thing to do is to leave economy alone

Case 1: SRS Shifts Left

Consider a natural disaster that destroys oil refineries.

Cost of oil increases.

This causes the SRS curve to shift left

Result: Lower output Higher prices (inflation)

Case 1: SRS Shifts Left

Aggregate Output, Y

P

2.

1.

Case 1: Keynsian View

Wages are slow to adjust, so the economy can stay out of equilibrium for several years. This is believed to be particularly true when the labor

market is slack Unions, for example, prevent employers from lowering

wages

Increased money supply can increase aggregate demand. Lower unemployment (higher output) at the cost of inflation. Keynsian view: benefit outweighs costs

Case 1: Keynsian View of Government Action

Aggregate Output, Y

P

2.

1.

3.

Case 1: Monetariast View

Wages adjust rather quickly – at least faster than the government has time to act.

Correct action is to let the economy alone.

If government acts: Increased volatility of output and prices Inflation

Case 1: Monetariast View of Government Action

Aggregate Output, Y

P

2.

1&3.

4.5.

Case 1: Monetariast View of No Government Action

Aggregate Output, Y

P

2.

1&3

Non-activist Argument

Data Lag – it takes time for policy makers to obtain the data that tell them what’s going on. Data on quarterly GDP not available for several months until

after the quarter.

Recognition lag – it takes time for policy makers to realize what the data is saying about the future. NBER won’t classify the economy in a recession until 6

months after it determines one might have begun.

Effectiveness lag – Once money supply has changed, it can take time for effects to be carried out

Case 2: AD Shifts Left

Keynsians: AD curve shifts left with Decrease in money supply (bank failures) Irrational pessimism by consumers

Monetariasts: AD curve shifts left with Decrease in money supply (bank failures)

Result: Lower output Lower prices (deflation)

Case 2: AD Shifts Left

Aggregate Output, Y

P

2. 1.

Case 2: Keynsian View

Wages are slow to adjust, so the economy can stay out of equilibrium for several years. This is believed to be particularly true when the labor

market is slack Unions, for example, prevent employers from lowering

wages

Increased money supply can increase aggregate demand. Lower unemployment (higher output) Prices restored to original level

Case 2: Keynsian View of Government Action

Aggregate Output, Y

P

2.

1&3

Case 2: Monetariast View

Wages adjust rather quickly – at least faster than the government has time to act.

Correct action is to let the economy alone.

If government acts: Increased volatility of output and prices Inflation

Case 2: Monetariast View of Government Action

Aggregate Output, Y

P

2.

1&5

3.

4.

Case 2: Monetariast View of No Government Action

Aggregate Output, Y

P

2.

3.

1.

Case 3: AD Shifts Right

Keynsians: AD curve shifts right with Increase in money supply (loose credit) Irrational exuberance by consumers

Monetariasts: AD curve shifts right with Increase in money supply (loose credit)

Result: Tight labor market Higher prices (inflation)

Case 3: AD Shifts Right

Aggregate Output, Y

P

2.

1.

Case 3: Keynsian View

Wages are slow to adjust When they do, result will be high inflation

Decreased money supply can decrease aggregate demand. Output restored to equilibrium Prices restored to original level

Case 3: Keynsian View of Government Action

Aggregate Output, Y

P

2.

1&3

Case 3: Monetariast View

Wages adjust rather quickly – at least faster than the government has time to act.

Correct action is to let the economy alone.

If government acts: Increased volatility of output and prices Deflation

Case 3: Monetariast View of Government Action

Aggregate Output, Y

P

2.

1&5

4.

3.

Case 3: Monetariast View of No Government Action

Aggregate Output, Y

P

2.

1

3.

Successful Active Monetary Policy

New Zealand

Canada

United Kingdom

United States