Monetary Theory:Monetary Theory:

ECO 473 – Money & Banking – Dr. D. Foster

The AD/AS Model – Pt. IThe AD/AS Model – Pt. I

Warning .. Warning .. WarningWarning .. Warning .. Warning

• Aggregate Supply and Aggregate Demand are not Aggregate Supply and Aggregate Demand are not like market supply & demand !!!!!like market supply & demand !!!!!

• The “static” analysis only hints at dynamic The “static” analysis only hints at dynamic interpretation.interpretation.

• Ceteris Paribus assumption problematic to the point Ceteris Paribus assumption problematic to the point of being wholly inappropriate.of being wholly inappropriate.

Contrasting views:Classical/Monetarist vs.

KeynesianFriedman vs. Keynes

Non-activist vs. Activist

The Aggregate Demand ScheduleThe Aggregate Demand Schedule

AD1

P

Q or R-GDP

BP1

Q2

AP2

Q1

P = Price Level;CPI or GDP deflator

Q = Y = Real GDP; (real output)

AD = Agg. Demand;From 4 sectors – HH, Bus, G, Foreign

Aggregate DemandAggregate Demand

• The price level and real output demanded are The price level and real output demanded are inversely related.inversely related.

• A fall in the price level will increase quantity A fall in the price level will increase quantity demanded.demanded.

• Why? -- the Why? -- the Real Balances EffectReal Balances Effect

• All prices and wages change.All prices and wages change.

• But, our fixed money holdings are … well, still fixed!But, our fixed money holdings are … well, still fixed!

• So, with lower prices we feel wealthier. Woo Hoo!So, with lower prices we feel wealthier. Woo Hoo!

• And, so we want to buy more stuff.And, so we want to buy more stuff.

Aggregate DemandAggregate Demand

• What about:What about:

Interest effectInterest effect Foreign trade effectForeign trade effect Exchange rate effectExchange rate effect

• AD can shift to the left or right.AD can shift to the left or right.

Increase AD – shift to the right.Increase AD – shift to the right.

Decrease AD – shift to the left.Decrease AD – shift to the left.

Whenever C, I, G, net X increase/decrease.Whenever C, I, G, net X increase/decrease.

Why? Due to changes in the money supply!Why? Due to changes in the money supply!

Can’t do “all else equal.”Can’t do “all else equal.” e.g. e.g. Price of apples - Price of apples - QQDD for apples ... for apples ...

and the and the QQDD for oranges. for oranges.

But, But, Price of everything and their isn’t Price of everything and their isn’t anything else to hold constant! anything else to hold constant!

The Aggregate Demand ScheduleThe Aggregate Demand Schedule

AD2

AD1

P

Q or R-GDP

AD3

Increases inC, I, G, net

X

Decreases in

C, I, G, net X

Money and Aggregate DemandMoney and Aggregate Demand

• Equation of exchangeEquation of exchange: An accounting identity:

• Quantity theory of moneyQuantity theory of money:People hold money for transactions purposes.Velocity (V) is constant, or, at least, stable (=1/k).Real output (Y) is constant w.r.t. labor supply.

Therefore, changes in MS will only change P.

• Aggregate Demand for output (AD) - derived from the demand for money, or - derived from the real balance effect.

MS * V = P * Y

MD = k * P * Y

AD2 MS/(k*P)

AD1

P

Q or R-GDP

AD3 MS/(k*P)

Increases in MS

Decreases

in MS

MD = MS

MS = k * P * Y

MS/(k * P) = Y

AD = MS/(k *

P)

QTM & The Aggregate Demand ScheduleQTM & The Aggregate Demand Schedule

The Money Supply and the Long Run Equilibrium The Money Supply and the Long Run Equilibrium between Aggregate Demand and Aggregate Supplybetween Aggregate Demand and Aggregate Supply

It is unaffected by changes in the price level, but is

affected by a host of real variables…

AD1

P

Q or R-GDP

ASLR

P1

Classical Model of the Economy

There is a “long run” Aggregate Supply,which is perfectly

verticalat the “full

employment”level of Real GDP.

The Money Supply and the Long Run Equilibrium The Money Supply and the Long Run Equilibrium between Aggregate Demand and Aggregate Supplybetween Aggregate Demand and Aggregate Supply

MS and that increases AD. MS and that

decreases AD.

AD1

P

Q or R-GDP

AS1

P1

Shifts in AD can only change the price level

and not real output (nor employment).

““Inflation is always, Inflation is always, and everywhere, a and everywhere, a

monetary monetary phenomenon.”phenomenon.”

-Milton Friedman

What affects the Aggregate Supply?What affects the Aggregate Supply?

• Labor force participation.

• Labor productivity.

• Marginal tax rates on wages.

• Provision of government benefits that affect household incentives w.r.t. supply labor.

• State of technology.

• Capital stock.A change in these

factors can AS (shift right)

or AS (shift left)

Short Run Aggregate Supply – Wage InflexibilityShort Run Aggregate Supply – Wage Inflexibility

• Nominal wages are sluggishsluggish upwards:A rise in prices has delayed effect on wages.

• Nominal wages are inflexibleinflexible downwards:A fall in prices will result in employment and y.

• Workers have money illusionmoney 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%…e.g. if prices rise 5% and wages rise 3%…

Short Run Aggregate SupplyShort Run Aggregate Supply

• The Short Run will adjust to the Long RunThe 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:What about:

Sticky pricesSticky prices MisperceptionMisperception Intertemporal substitutionIntertemporal substitution

Unnecessary complicationsUnnecessary complicationsto explain the SR AS.to explain the SR AS.

Inflexible wages is all we need.Inflexible wages is all we need.

What happens if there is a AD?

Monetary Theory:Monetary Theory:

ECO 473 – Money & Banking – Dr. D. Foster

The AD/AS Model – Pt. IThe AD/AS Model – Pt. I