R GLENN HUBBARD ANTHONY PATRICK O’BRIEN Money, Banking, and the Financial System © 2012 Pearson Education, Inc Publishing as Prentice Hall CHAPTER 17 Monetary Theory I: The Aggregate Demand and Aggregate Supply Model LEARNING OBJECTIVES After studying this chapter, you should be able to: 17.1 Explain how the aggregate demand curve is derived 17.2 Explain how the aggregate supply curve is derived 17.3 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 © 2012 Pearson Education, Inc Publishing as Prentice Hall CHAPTER 17 Monetary Theory I: The Aggregate Demand and Aggregate Supply Model 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 © 2012 Pearson Education, Inc Publishing as Prentice Hall 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? © 2012 Pearson Education, Inc Publishing as Prentice Hall of 41 17.1 Learning Objective Explain how the aggregate demand curve is derived © 2012 Pearson Education, Inc Publishing as Prentice Hall of 41 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 Curve © 2012 Pearson Education, Inc Publishing as Prentice Hall of 41 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 balances The 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 Curve © 2012 Pearson Education, Inc Publishing as Prentice Hall of 41 Figure 17.2 The Market for Money 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)1S to (M/P)S2 , thereby increasing the equilibrium interest rate from i1 to i2. The Aggregate Demand Curve â 2012 Pearson Education, Inc Publishing as Prentice Hall of 41 Shifts of the Aggregate Demand Curve Table 17.1 Determinants of Shifts in the Aggregate Demand Curve The Aggregate Demand Curve © 2012 Pearson Education, Inc Publishing as Prentice Hall of 41 Shifts of the Aggregate Demand Curve Table 17.1 Determinants of Shifts in the Aggregate Demand Curve (continued) The Aggregate Demand Curve © 2012 Pearson Education, Inc Publishing as Prentice Hall 10 of 41 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 Equilibrium in the Aggregate Demand and Aggregate Supply Model © 2012 Pearson Education, Inc Publishing as Prentice Hall 27 of 41 17.4 Learning Objective Use the aggregate demand and aggregate supply model to show the effects of monetary policy © 2012 Pearson Education, Inc Publishing as Prentice Hall 28 of 41 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 Policy © 2012 Pearson Education, Inc Publishing as Prentice Hall 29 of 41 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 Policy © 2012 Pearson Education, Inc Publishing as Prentice Hall 30 of 41 An Expansionary Monetary Policy Figure 17.6 (2 of 2) The Effects of Monetary Policy © 2012 Pearson Education, Inc Publishing as Prentice Hall 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.• 31 of 41 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 © 2012 Pearson Education, Inc Publishing as Prentice Hall 32 of 41 Solved Problem 17.4 Dealing with Shocks to Aggregate Demand and Aggregate Supply Step Review the chapter material Step Answer 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 © 2012 Pearson Education, Inc Publishing as Prentice Hall 33 of 41 Solved Problem 17.4 Dealing with Shocks to Aggregate Demand and Aggregate Supply Step Answer part (b) by drawing the appropriate graph The Effects of Monetary Policy © 2012 Pearson Education, Inc Publishing as Prentice Hall 34 of 41 Solved Problem 17.4 Dealing with Shocks to Aggregate Demand and Aggregate Supply Step Answer part (c) by redrawing the appropriate graph The Effects of Monetary Policy © 2012 Pearson Education, Inc Publishing as Prentice Hall 35 of 41 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 Policy © 2012 Pearson Education, Inc Publishing as Prentice Hall 36 of 41 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 The Effects of Monetary Policy © 2012 Pearson Education, Inc Publishing as Prentice Hall 37 of 41 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 © 2012 Pearson Education, Inc Publishing as Prentice Hall 38 of 41 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 © 2012 Pearson Education, Inc Publishing as Prentice Hall 39 of 41 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 © 2012 Pearson Education, Inc Publishing as Prentice Hall 40 of 41 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 SRAS1 to SRAS2 and 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 © 2012 Pearson Education, Inc Publishing as Prentice Hall 41 of 41 ... 41 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. .. balances The 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. . .CHAPTER 17 Monetary Theory I: The Aggregate Demand and Aggregate Supply Model LEARNING OBJECTIVES After studying this chapter, you should be able to: 17. 1 Explain how the aggregate demand