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R. GLENN HUBBARD ANTHONY PATRICK O’BRIEN. Money, Banking, and the Financial System. Monetary Theory I: The Aggregate Demand and Aggregate Supply Model. 17. C H A P T E R. LEARNING OBJECTIVES. After studying this chapter, you should be able to:.

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r glenn hubbard anthony patrick o brien

R. GLENNHUBBARDANTHONY PATRICKO’BRIEN

Money,Banking, andthe Financial System

monetary theory i the aggregate demand and aggregate supply model
Monetary Theory I: TheAggregate Demand andAggregate Supply Model

17

C H A P T E R

LEARNING OBJECTIVES

After studying this chapter, you should be able to:

Explain how the aggregate demand curve is derived

17.1

Explain how the aggregate supply curve is derived

17.2

Demonstrate macroeconomic equilibrium using the aggregate demand and aggregate supply model

17.3

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

monetary policy

17.4

monetary theory i the aggregate demand and aggregate supply model1
Monetary Theory I: TheAggregate Demand andAggregate Supply Model

17

C H A P T E R

  • 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.
slide4

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?

slide5

17.1

Learning Objective

Explain how the aggregate demand curve is derived.

the aggregate demand curve
The Aggregate Demand Curve

Aggregate expenditure (AE) on the economy’s output of goods and services equals:

Aggregate demand (AD) curve A curve that shows the relationship between aggregate expenditure on goods and services and the price level.

Figure 17.1

The Aggregate Demand Curve

The aggregate demand, AD, curve shows the relationship between the price level and the level of aggregate expenditure.•

the aggregate demand curve1
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.

Real money balancesThe value of money held by households and firms, 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 curve2
The Aggregate Demand Curve

The Market for Money

Figure 17.2

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.•

1

2

the aggregate demand curve3
The Aggregate Demand Curve

Shifts of the Aggregate Demand Curve

Determinants of Shifts in the Aggregate Demand Curve

Table 17.1

the aggregate demand curve4
The Aggregate Demand Curve

Shifts of the Aggregate Demand Curve

Determinants of Shifts in the Aggregate Demand Curve (continued)

Table 17.1

slide11

17.2

Learning Objective

Explain how the aggregate supply curve is derived.

the aggregate supply curve
The Aggregate Supply Curve

Aggregate supplyThe total quantity of output, or GDP, that firms are willing to supply at a given price level.

Short-run aggregate supply (SRAS) curveA curve that shows the 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 curve1
The Aggregate Supply Curve

The Short-Run Aggregate Supply (SRAS) Curve

The new classical view, also sometimes called the misperception theory emphasizes the difficulty firms have in distinguishing between relative price increases from general price increases.

If all prices in the economy rise but relative prices don’t change, and individual producers fail to recognize this situation, then aggregate output increases.

Conversely, if all producers expect the price level to increase by 10%, and the price level actually increases by only 5%, producers (having expected a 10% increase in the price level) will collectively cut production.

If P is the actual price level and Pe is the expected price level, the relationship between aggregate output and the price level, according to the new classical view is

If , then . If , then will increase. If , then will decrease.

the aggregate supply curve2
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 curve3
The Aggregate Supply Curve

The Long-Run Aggregate Supply (LRAS) Curve

Long-run aggregate supply (LRAS) curve A curve that shows the relationship 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 aggregate supply curve4
The Aggregate Supply Curve

Figure 17.3

The Short-Run and Long-Run Aggregate Supply Curves

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.

slide17

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 curve5
The Aggregate Supply Curve

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

Supply shock An unexpected change in production costs or in technology that 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).

the aggregate supply curve6
The Aggregate Supply Curve

Table 17.2

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

the aggregate supply curve7
The Aggregate Supply Curve

Table 17-2 (continued)

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

slide21

17.3

Learning Objective

Demonstrate macroeconomic equilibrium using the aggregate demand and

aggregate supply model.

equilibrium in the aggregate demand and aggregate supply model
Equilibrium in the Aggregate Demand and Aggregate Supply Model

Short-Run Equilibrium

Figure 17.4

Short-Run Equilibrium

The economy’s short-run equilibrium is represented by 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 model1
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 AD1to AD2, increasing output from YPto 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 model2
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.

Monetary neutrality The proposition that changes in the money supply have 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 model3
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 model4
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 model5
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.

slide28

17.4

Learning Objective

Use the aggregate demand and aggregate supply model to show the effects of monetary policy.

the effects of monetary policy
The Effects of Monetary Policy

Business cycle Alternating periods of economic expansion and economic recession.

Stabilization policy A monetary policy or fiscal policy intended to reduce the severity of the business cycle and stabilize the economy.

the effects of monetary policy1
The Effects of Monetary Policy

An Expansionary Monetary Policy

Figure 17.6 (1 of 2)

Effects of 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.

the effects of monetary policy2
The Effects of Monetary Policy

An Expansionary Monetary Policy

Figure 17.6 (2 of 2)

Effects of 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.•

slide32

17.4

Solved Problem

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

slide33

17.4

Solved Problem

Solved Problem

Dealing with Shocks to Aggregate Demand and Aggregate Supply

Step 1Review the chapter material.

Step 2Answer part (a) by drawing the appropriate graph and explaining whether we know whether the price level will rise or fall.

The Effects of Monetary Policy

slide34

17.4

Solved Problem

Solved Problem

Dealing with Shocks to Aggregate Demand and Aggregate Supply

Step 3Answer part (b) by drawing the appropriate graph.

The Effects of Monetary Policy

slide35

17.4

Solved Problem

Solved Problem

Dealing with Shocks to Aggregate Demand and Aggregate Supply

Step 4Answer part (c) by redrawing the appropriate graph.

The Effects of Monetary Policy

the effects of monetary policy3
The Effects of Monetary Policy

Was Monetary Policy Ineffective during the 2007–2009 Recession?

As we saw in the chapter opener, in late 2010, the U.S. unemployment rate remained stubbornly high, and increases in real GDP were disappointingly modest. Do these facts indicate that monetary policy had failed?

Certainly, the Fed was unable to pull off a rapid and smooth return to full employment of the type illustrated in panel (b) of Figure 17.6.

However, recessions started by financial crises are almost always very severe. The 2007–2009 recession was not a temporary decline in aggregate demand but the result of structural, perhaps permanent, changes in the economy. Unemployed workers might need to be retrained for other jobs or relocate to find work.

Some economists believe that large negative shifts in aggregate demand actually reduce the full employment level of output in a process known as hysteresis.

the effects of monetary policy4
The Effects of Monetary Policy

Persistently high rates of unemployment in many European countries during the 1980s and 1990s may reflect hysteresis.

Government policies, such as generous unemployment insurance benefits, high tax rates, and hiring and firing restrictions, may also help to explain why employment growth was sluggish in these countries.

Fed Chairman Ben Bernanke referred to the problems with aggregate supply as the “unusual uncertainty” in the economic situation. Given that the financial crisis and recession of 2007–2009 were more severe than any since World War II, an increased level of uncertainty was unavoidable.

Conventional expansionary monetary policy would be effective only if the main problem facing the economy was insufficient aggregate demand. Since the economy was sailing in largely uncharted waters, it was unclear whether aggregate demand or aggregate supply was the bigger problem.

slide38

Making the Connection

Is It Like 1939?

Do the events from the Great Depression provide an insight into the recession of 2007–2009? Was the high unemployment of 1939 due to problems with aggregate demand or aggregate supply?

Problems with the aggregate supply included substantial increases in tax rates; a sharp increase in unionization, strikes, and labor unrest; and an apparent undermining of private property rights.

Hysteresis and “regime uncertainty” are some of the possible explanations for insufficient aggregate demand.

Undoubtedly, economists will continue to explore the surprising parallels between the U.S. economy of the 1930s and the U.S. economy following the beginning of the financial crisis in 2007.

The Effects of Monetary Policy

slide39

Answering the Key Question

At the beginning of this chapter, we asked the question:

“What explains the high unemployment rates during the economic expansion that began in 2009?”

As we have seen in this chapter, in late 2010, the unemployment rate remained above 9%, which was unusually high for the post-World War II period. Economists disagree about why the unemployment rate was so high. Some economists believed that it was due to insufficient aggregate demand and suggested that production and employment could be expanded with conventional macroeconomic stabilization policies. Other economists, though, saw problems with aggregate supply, either because of potentially long-lived declines in the importance of residential construction and automobile industries or because of increased economic uncertainty.

slide40

AN INSIDE LOOK AT POLICY

Unemployment Stays High Despite Low Interest Rates, Fiscal Stimulus

INTERNATIONAL BUSINESS TIMES, Fed Officials See High Unemployment for Years

Key Points in the Article

  • Federal Reserve officials acknowledged that unemployment in the United States would remain high for years. They stressed that the Federal Reserve would maintain an accommodative monetary policy that had already pumped more than $1 trillion into the economy.
  • Although the financial crisis was subsiding, lending could take years to return to pre-crisis levels.
  • Within the Fed, some of the most contentious debates center around the outlook for inflation, with some worried about prices rising too fast, and others worried about disinflation.
  • Businesses in the United States are still responding to “replacement demand” rather than the “expansionary demand” needed to boost economic growth.
slide41

AN INSIDE LOOK AT POLICY

The graph above shows the economy before the recession, in long-run equilibrium at E1 (output = YP, price level = P1).

The recession was caused by a housing and financial crisis, which shifted aggregate demand from AD1 to AD2.

Eventually, the short-run supply curve could shift from SRAS1to SRAS2and the economy would return to equilibrium at E3, but this could take years, and Fed officials feared that the disinflation—or deflation—that this requires could lead to another recession.