Monetary Theory The ADAS Model Pt II ECO

Monetary Theory: The AD/AS Model – Pt. II ECO 473 – Money & Banking – Dr. D. Foster

AS/AD Model – Hints at 4 types of changes: P ASLR AS 1 • Inflation with growth due to rising AD. • Depression with deflation due to falling AD. • Growth with deflation due to rising AS. • Depression with inflation due to falling AS. (stagflation) P 1 AD 1 Q* Q or R-GDP

The Transmission Mechanism of Monetary Policy • Assume: • • money multiplier is 2. 5 interest rates change by 1% per $80 b ΔMS investment changes by $35 b per 1% Δi income rises $5 for each $1 increase in spending (AD) How much will income change by if the Fed buys $10 billion worth of bonds? How much will income change by if the Fed sells $15 billion worth of bonds?

Are Monetary Policies Effective? • In the Short Run only: Ø If they are unexpected. Ø If wage/price rigidities persist. Ø Over time, these should be less likely. • How effective? Ø The liquidity effect – How responsive are interest rates to changes in the money supply? [∆i is 3% …] Ø The interest elasticity of investment – How responsive is investment to a change in interest rates? [∆I is $50 b. …]

Velocity of M 1: 1970 - 2017 Q 3: 5. 5

Monetarist vs. Keynesian What are the initial causes of a recession? Money Supply Investment The Fed as source. Lack of “animal spirits. ” How fast can the economy recover? Very fast. Not very fast. Gov’t as source of disruption. Market instability. How does monetary policy help? It has a direct effect on consumer spending. Works through effects on investment spending. Very powerful. Likely ineffective. “Pushing on a string. ” Should the government aid in the recovery? No – use rules. Yes – use discretion.

Keynesian vs. Monetarist & the SR AS P ASLR AS - Monetarist The AS is flat in the Keynesian view and steep according to the Monetarists. AS - Keynes P 1 AD 1 So, a decrease in the AD will have different consequences in the two theories. AD 2 Q* Q or R-GDP

Persistent inflation & inflationary expectations P AS 4 AS 5 P 4 P 3 P 2 P 1 Q* AS 3 The Fed tries to AS 2 reduce unemployment and increase output by AS 1 MS. This AD. With a lag, the AS will decrease so all we see is P. The Fed keeps trying, but now no lag in AS. If the Fed stops AD 2 inflationary AD 2 expectations AD 1 will continue to AS, now Q. Q or R-GDP

Can we eliminate inflation by AS (short run)? § No, these policies are “doomed to failure. ” • Wage & price controls • Tax-based Incomes policies (TIPs) To eliminate inflation we must AD § We’ll have to contend with inflationary expectations. • Gradualism approach • Going cold turkey

Current Problems & Policy Questions Prices • Decreased AD sends us into recession. ASLR ASSR • Fed expands the MS to stimulate economic growth. Doesn’t work. P 3 AD’’’ P 1 AD P 2 AD’’ • Eventually, there’s an overreaction, and sharply rising AD leads to high levels of inflation. AD’ Q’ Q* Q = Real GDP Will this be the result of the Fed’s having MB to $4. 5 tr and ER to $2. 6 tr?

Monetary Theory: The AD/AS Model – Pt. II ECO 473 – Money & Banking – Dr. D. Foster