**Unformatted text preview: **Money and Banking
Econ 310 IS-LM Model
i,r LM r* IS Y Y* IS-LM Model and the Fixed Aggregate Price Level Hangover from Keynes' original analysis Response to Great Depression scenario Inflation was not an issue Keynes did not identify a significant role for monetary policy Relatively flat LM curve implied that fiscal policy was very effective at stimulating aggregate demand Also implied that monetary policy wasn't likely to be very effective Consequence of Liquidity Trap Problem: ISLM model won't portray the consequences of monetary changes under different assumptions Keynesian Monetary Theory Equilibrium: M/P = md(i, Y) Concern over liquidity trap: md very sensitive to changes in i Small changes in interest rates are sufficient to equilibrate the money market Investment will not be affected significantly when nominal money supply varies Aggregate demand will not vary significantly with changes in nominal money supply Contrast with quantity theory Monetarist Monetary Theory Quantity Theory: M/P = Y/v Y is determined independently of the monetary sector v is constant Changes in M will translate wholly into changes in P Friedman proposed a "new quantity theory" M/P = f(Yp) Yp is not volatile Therefore changes in M translate wholly into changes in P ISLM cannot capture these effects due to the fixed nature of prices Endogenizing Price Level in the IS-LM model Only role for the price level in the ISLM model is to shifts LM curve: We can use this to track through the equilibrium effects of changing P md(i, Y) = M/P Impact on r Impact on Y Capture the impact on Y from a change in P Aggregate Demand Curve
i,r LM(M/P0) LM(M/P1) IS Y P P0 P1 Aggregate Demand (AD) Y
0 Y 1 Y Aggregate Demand Curve Not a real "demand curve" Collects combinations of P and Y associated with equilibrium in the ISLM model Points off the AD curve represent disequilibrium in the ISLM model Despite this, it LOOKS like a demand curve, and ACTS like one too Shifting the AD Curve AD curve shifts with changes in any exogenous variables in ISLM model (except for the price level): Government spending Tax receipts Autonomous consumption Exogenous investment demand factors Nominal money supply Exogenous money demand factors "consumer confidence" "business confidence" Asset market liquidity Expectations of future interest rates Etc Example: increase in G
i,r LM(M/P) IS 0 IS1 Y P P AD0 Y0 Y1 AD1 Y Example: increase in M
i,r LM(M0/P) LM(M1/P) IS0 Y P P AD0 Y0 Y1 AD1 Y The Keynesian World: IS-LM and the AD curve Keynes envisages prices as fixed Think of this as a specific constraint imposed on the AD model Characterize this constraint as an AGGREGATE SUPPLY curve that is perfectly elastic at the specified price Firms respond passively to changes in aggregate demand If aggregate demand increases at the current price, firms will simply increase production Result of firms replacing dwindling inventories Keynesian AD-AS Model
i,r LM(M/P0) IS P P0 AS Y AD Y Y Keynesian AD-AS Model: Fiscal Policy i,r
LM(M/P0) IS P P0 IS' Y AS AD Y AD' Y Keynesian AD-AS Model: Monetary Policy i,r
LM(M0/P0) LM(M1/P0) IS P P0 AS Y AD Y AD' Y Price Rigidity Hard to justify firms' passive response to changes in aggregate demand Most (micro) models argue that profit maximizing firms respond to changes in prices Keynes' fixed price model is, at best, a very short run model in which prices are unable to adjust at all Upward sloping supply curves If fiscal policy generates increases in aggregate demand, then excess demand for goods will force prices up Rigid or "sticky" prices Price Flexibility Assume prices respond to excess demand/supply in the goods market Also assume factor prices respond to disequilibrium in factor markets Example: labor market equilibrium For given technology and preferences, there exists an equilibrium real wage: W/P Real wage is the share of output that must be paid to the worker Firms' supply and workers' supply decisions respond to real wages Example: the labor market
W/P Ls W/P = w* Ld L L* Full Employment Full Employment is attained when the unfettered labor market clears L* in the previous diagram Some unemployment (frictional, seasonal) L* depends on: firm technology and worker preferences Labor market adjusts the real wage to clear the labor market at this level of employment Independent of the level of P W can adjust so that W/P = w* Price Flexibility If Then goods prices (P) are flexible; and factor prices (for example nominal wages, W) are flexible Employment will adjust to the full employment level, L* This is independent of the aggregate price level, P Aggregate Supply Curve Regardless of aggregate price, P, employment will tend to the "natural" level Output will tend to the "full employment level", Y* That level of output associated with full employment in factor markets Aggregate Supply when all prices are flexible
P AS Y* Y Equilibrium in the Flexible Price AS-AD model
P AS P* AD Y Yn i,r Neutrality of Money
LM(M10/P0) LM(M/P1) LM(M1/P0) IS0 P P1 P0 Y AD0 Y* Y1 AD1 Y Friedman's Monetary Policy Money is "Neutral" Expansionary monetary policy causes interest rates to fall Investment is stimulated Aggregate demand rises and exceeds the natural level of output Price rises, shifting the LM curve to the left Interest rates rise again Investment is totally crowded out Essentially the quantity theory result ...

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