im26 - Chapter 26 Money and Output in the Short Run...

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Chapter 26 Money and Output in the Short Run Overview This chapter explores the link between changes in the money supply and changes in output and prices in the short run. It does so by weaving together theoretical, empirical, and policy topics. A focus of the discussion is whether the Fed should attempt to smooth out upturns and downturns in the economy. The empirical evidence on the correlation between money and output over the cycle is presented and the explanations offered for this correlation by the real business cycle, new Keynesian, and new classical models are discussed. Particularly for those courses that emphasize policy, this chapter will provide students with the background to understand the theoretical underpinnings of current policy disputes. Once again, students who have had a course in intermediate macroeconomics will find the material in this chapter to be rather easy going. Instructors desiring an applied orientation can introduce the idea that exogenous changes in the nominal money supply affect output in the short run and then cover the policy applications presented. The correlation between money and output is accounted for in the real business cycle model by the assumption that reverse causation is at work: Changes in output lead to changes in the demand for money, which the Fed passively responds to by changing the money supply. The evidence against reverse causation provided by Friedman and Schwartz, and more recently by Christina and David Romer, is reviewed. In the new classical model, changes in the money supply affect output only if the changes are unexpected. The empirical evidence indicates that both expected and unexpected changes in the money supply affect output (this evidence was discussed in an appendix in the second edition; it is now on the Web site). The chapter analyzes the differing approaches of the real business cycle, new classical, and new Keynesian models to the utility of stabilization policy. The real business cycle model leaves no room for stabilization policy because movements in output are caused by shocks to technology. In the new classical model, only unanticipated policy affects output because prices are perfectly flexible and agents have rational expectations. In the new Keynesian view, price stickiness allows policy to affect output and raises the possibility of carrying out an effective stabilization policy. Lags in the policymaking and implementation process may make fine-tuning the economy difficult, however. The chapter concludes by applying the models to explain events in the 1980s, 1990s and early 2000s. Outline I. Tracking Money and Output Movements in the Short Run A) Both money and output fluctuate over the short run as the economy moves through the business cycle . B)
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im26 - Chapter 26 Money and Output in the Short Run...

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