Money banking and the financial system 1e by hubbard and OBrien chapter 17

Monetary Theory I: The Aggregate Demand and Aggregate Supply ModelC H A P T E R 17 LEARNING OBJECTIVES After studying this chapter, you should be able to: 17.1 17.2 17.3 Explain how the

R GLENN

HUBBARD

ANTHONY PATRICKO’BRIEN

Money, Banking, and the Financial

System

Monetary Theory I: The Aggregate Demand and Aggregate Supply Model

C H A P T E R 17

LEARNING OBJECTIVES

After studying this chapter, you should be able to:

17.1 17.2 17.3

Explain how the aggregate demand curve is derived Explain how the aggregate supply curve is derived

Demonstrate macroeconomic equilibrium using the aggregate demand and aggregate supply model

17.4 Use the aggregate demand and aggregate supply model to show the effects of

monetary policy

IS THE UNITED STATES FACING A “NEW NORMAL” OF HIGHER

UNEMPLOYMENT?

•“The Great Recession” began in December 2007 and ended in July 2009 Yet, the unemployment rate actually increased after the end of the recession

•Economic growth is not predicted to be fast enough to bring these high

unemployment rates down any time soon Economists have begun speaking of the “new normal,” in which unemployment rates might be stuck at higher levels for many years

•Adjusting to structural changes in the economy may take considerable time

•Read AN INSIDE LOOK AT POLICY on page 538 for a discussion of Fed’s

forecasts of future unemployment

C H A P T E R 17 Monetary Theory I: The

Aggregate Demand and Aggregate Supply Model

Key Issue and Question

Issue: During the recovery from the financial crisis, the unemployment

rate remained stubbornly high

Question: What explains the high unemployment rates during the

economic expansion that began in 2009?

17.1 Learning Objective

Explain how the aggregate demand curve is derived

The Aggregate Demand Curve

The aggregate demand, AD,

curve shows the relationship

between the price level and

the level of aggregate

expenditure •

Figure 17.1

The Aggregate Demand

Curve

The Aggregate Demand Curve

The Market for Money and the Aggregate Demand Curve

The market for money involves the interaction between the demand for M1—

currency plus checkable deposits—by households and firms and the supply of

M1, as determined by the Federal Reserve

The analysis of the market for money is sometimes referred to as the liquidity

preference theory, a term coined by the British economist John Maynard Keynes.

adjusted for changes in the price level; M/P.

The primary reason households and firms demand money is called the

transactions motive—to hold money as a medium of exchange

Households and firms face a trade-off The higher the interest rate on short-term assets such as Treasury bills, the more households and firms give up when they hold large money balances So, the short-term nominal interest rate is the

opportunity cost of holding money

The Aggregate Demand Curve

In panel (a), the demand for real balances is downward sloping because higher short-term interest rates increase the opportunity cost of holding money

The supply of real balances is a vertical line because we assume for simplicity that the

Fed can control perfectly the level of M1.

In panel (b),we show that an increase in the price level causes the supply curve for real

balances to shift from (M/P)S to (M/P)S , thereby increasing the equilibrium interest rate

from i1 to i2 •

The Aggregate Demand Curve

Shifts of the Aggregate Demand Curve

The Aggregate Demand Curve

Shifts of the Aggregate Demand Curve

17.2 Learning Objective

Explain how the aggregate supply curve is derived

The Aggregate Supply Curve

supply at a given price level

relationship in the short run between the price level and the quantity of

aggregate output, or real GDP, supplied by firms

Though the short-run aggregate supply curve slopes upward like the supply

curve facing an individual firm, it represents different behavior

Next we examine the new classical and new Keynesian views that attempt to

explain why the SRAS curve slopes upward.

The Aggregate Supply Curve

The Short-Run Aggregate Supply (SRAS) Curve

The Aggregate Supply Curve

An alternative explanation for why the SRAS curve is upward sloping comes

from the argument of John Maynard Keynes and his followers that prices adjust slowly in the short run in response to changes in aggregate demand That is,

prices are sticky in the short run

In the most extreme view of price stickiness, we would observe a horizontal

SRAS curve because prices would not adjust at all to increases or decreases in

aggregate demand Rather, firms would adjust their production levels to meet

the new level of demand without changing their prices

Contemporary followers of Keynes’s view have sought reasons for the failure of

prices to adjust in the short run Economists who embrace the new Keynesian

view use characteristics of many real-world markets—rigidity of long-term

contracts and imperfect competition—to explain price behavior

New Keynesian economists argue that prices will adjust only gradually in

monopolistically competitive markets when there are costs to changing prices

The costs of changing prices are sometimes called menu costs.

The Aggregate Supply Curve

in the long run between the price level and the quantity of aggregate output, or

real GDP, supplied by firms

The long-run aggregate supply (LRAS) curve is vertical at YP

In the new Keynesian view, in the short run many input costs are fixed, so firms can expand output without experiencing an increase in input cost that is

proportional to the increase in the prices of their products Over time, though,

input costs increase in line with the price level, so both firms with flexible prices and firms with sticky prices adjust their prices in response to a change in

demand in the long run As with the new classical view, the LRAS curve is

vertical at potential GDP, or Y = YP

The Long-Run Aggregate Supply (LRAS) Curve

The Aggregate Supply Curve

The SRAS curve is upward

sloping: When the price level

P exceeds the expected price

level Pe , the quantity of output supplied rises

In the long run, the actual and expected price levels are the same Therefore, the

LRAS curve is vertical at

potential GDP,YP

Figure 17.3

The Short-Run and Run Aggregate Supply Curves

Long-Making the Connection

Shock Therapy and Aggregate Supply in Poland

In the early 1990s, the former Communist countries in Eastern Europe were

trying to reform their economies

To transform its centrally planned economy and remove price controls, Poland

chose shock therapy—pursuing radical reforms but much more rapidly than

other countries

The immediate result was a rise in the price level and a decline in output But

Polish policymakers were more interested in the long-run prospects for

economic growth than in the short-run changes in output

The gamble in Poland was that these short-term costs would be rewarded

handsomely in long-term gains in production and consumption possibilities for

Polish citizens

Many economists, notably Jeffrey Sachs of Columbia University, argued that

the rebound of the Polish economy in 1992 was the beginning of favorable

shifts in long-run aggregate supply in Poland The removal of central planning

and improvements in factory productivity shifted the LRAS curve to the right,

increasing output and dampening inflationary pressures

The Effects of Monetary Policy

The Aggregate Supply Curve

causes the short-run aggregate supply curve to shift

There are three main factors that cause the short-run aggregate supply curve to shift:

1 Changes in labor costs.

2 Changes in other input costs.

3 Changes in the expected price level.

Shifts in the Long-Run Aggregate Supply (LRAS) Curve

The LRAS curve shifts over time to reflect growth in the potential level of

output Sources of this economic growth include (1) increases in capital and

labor inputs and (2) increases in productivity growth (output produced per unit

of input)

Shifts in the Short-Run Aggregate Supply (SRAS) Curve

The Aggregate Supply Curve

Table 17.2

Determinants of Shifts in the Short-Run and Long-Run Aggregate Supply Curves

The Aggregate Supply Curve

Table 17-2 (continued)

Determinants of Shifts in the Short-Run and Long-Run Aggregate Supply Curves

17.3 Learning Objective

Demonstrate macroeconomic equilibrium using the aggregate demand and

aggregate supply model

Equilibrium in the Aggregate Demand and Aggregate Supply Model

the intersection of the AD and

SRAS curves at E1 The

equilibrium price level is P1 Higher price levels are associated with an excess

supply of output (at point A),

and lower price levels are associated with excess demand for output (at point

B).

Equilibrium in the Aggregate Demand and Aggregate Supply Model

Long-Run Equilibrium

Figure 17.5

Adjustment to Long-Run Equilibrium

From an initial equilibrium at E1, an increase in aggregate demand shifts

the AD curve from AD1 to AD2,

increasing output from YP to Y2.

Because Y is greater than YP , prices

rise, shifting the SRAS curve from

SRAS1 to SRAS2 The economy’s new equilibrium is at

E3 Output has returned to YP , but the

price level has risen to P2.

The LRAS curve is vertical at YP ,

potential GDP Shifts in the AD curve

affect the level of output only in the short run This outcome holds in both the new classical and new

Keynesian views, although price adjustment is more rapid in the new classical view.

Equilibrium in the Aggregate Demand and Aggregate Supply Model

Because the LRAS curve is vertical, economists generally agree that in the long

run changes in aggregate demand affect the price level but not the output level

no effect on output in the long run because an increase (decrease) in the

money supply raises (lowers) the price level in the long run but does not

change the equilibrium level of output

Equilibrium in the Aggregate Demand and Aggregate Supply Model

Economic Fluctuations in the United States

Shocks to Aggregate Demand, 1964–1969 During the Vietnam War, the Fed

was concerned that the rise in aggregate demand caused by increases in

government purchases would increase money demand and the interest rate To avoid an increase in the interest rate, the Fed pursued an expansionary

monetary policy Because fiscal and monetary expansion continued for several

years, AD–AS analysis indicates that output growth and inflation should have

risen from 1964 through 1969, and, in fact, that is what happened

Supply Shocks, 1973–1975 and after 1995 The early 1970s was a period of

rising inflation and falling output, stagflation, as a result of two negative supply

shocks: a sharp reduction in the supply of oil and poor crop harvests around the world The negative supply shocks shift the short-run aggregate supply curve to the left, raising the price level and reducing output A similar pattern occurred as

a result of negative supply shocks caused by rising oil prices in the 1978–1980

period In the late 1990s and 2000s, the U.S economy experienced favorable

supply shocks, such as the acceleration in productivity growth

Equilibrium in the Aggregate Demand and Aggregate Supply Model

Credit Crunch and Aggregate Demand, 1990–1991 A credit crunch was the

result of stringent bank regulation and declines in real estate values Because

households and businesses weren’t able to replace bank credit with funds from

other sources, consumer spending fell In AD–AS analysis, the decline in

spending reduces aggregate demand and puts downward pressure on prices,

shifting the SRAS curve down In fact, output growth fell during the 1990–1991

recession and inflation declined from 4.3% in 1989 to 2.9% in 1992

Investment and the 2001 Recession The brief recession of 2001 began as a

result of a decline in business investment In the late 1990s, many firms

invested heavily in information technology The U.S economy accumulated

more capital than businesses desired when expectations of future profitability

declined after 2000 In AD–AS analysis, the decline in planned investment

shifts the AD curve to the left, reducing both output growth and inflation

Fast-paced productivity growth during this period led to a rightward shift of the SRAS and LRAS curves and cushioned the decline in output.

Equilibrium in the Aggregate Demand and Aggregate Supply Model

Are Investment Incentives Inflationary? In the late 1990s, many economists

and policymakers urged consideration of tax reforms that would stimulate

business investment, such as expensing—writing off new plant and equipment

purchases at once instead of gradually—and reducing the cost of capital

through cuts in dividend and capital gains taxes

Many economists argued that such reforms would increase investment demand and output of capital goods Would they also increase inflation?

In AD–AS analysis, the stimulus to investment translates into an increase in

aggregate demand, shifting the AD curve to the right

However, as the new plant and equipment are installed, the economy’s capacity

to produce increases, and the SRAS and LRAS curves shift to the right,

reducing the inflationary pressure from pro-investment tax reform

Recent evidence suggests that the supply response is substantial and

investment incentives are unlikely to be inflationary

17.4 Learning Objective

Use the aggregate demand and aggregate supply model to show the effects of

monetary policy

The Effects of Monetary Policy

recession

severity of the business cycle and stabilize the economy

The Effects of Monetary Policy

An Expansionary Monetary Policy

Panel (a) shows that from

an initial full-employment

equilibrium at E1, an aggregate demand shock

shifts the AD curve from

AD1 to AD2, and output

falls from YP to Y2.

At E2, the economy is in a recession

Over time, the price level adjusts downward,

restoring the economy’s full employment

equilibrium at E3.

Figure 17.6 (1 of 2)

Effects of Monetary Policy

The Effects of Monetary Policy

An Expansionary Monetary Policy

Panel (b) shows that from

an initial full-employment

equilibrium at E1, an aggregate demand shock

shifts the AD curve from

AD1 to AD2

At E2, the economy is in a recession

The Fed speeds recovery, using an expansionary monetary policy, which

shifts the AD curve back from AD2 to AD1.

Relative to the nonintervention case, the economy recovers more quickly back to full

employment, but with a higher long-run price level •

Figure 17.6 (2 of 2)

Effects of Monetary Policy

Solved Problem 17.4

Dealing with Shocks to Aggregate Demand and Aggregate Supply

Assume that the economy is initially in equilibrium at full employment Then

suppose that the economy is hit simultaneously with negative aggregate

demand and aggregate supply shocks: There is a large increase in oil prices

and a sharp decline in consumption spending as households become

pessimistic about their future incomes

a Draw an aggregate demand and aggregate supply graph to illustrate the

initial equilibrium and the short-run equilibrium after the shocks Do we know

with certainty whether the price level will be higher or lower in the new

equilibrium?

b Suppose that the Fed decides not to intervene with an expansionary

monetary policy Show how the economy will adjust back to its long-run

equilibrium

c Now suppose that the Fed decides to intervene with an expansionary

monetary policy If the Fed’s policy is successful, show how the economy

adjusts back to its long-run equilibrium

The Effects of Monetary Policy