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•Still, this modification of the classical model does not change the classical view to limit the role of fiscal policy in downturns. An increase in aggregate demand does not directly address the problem of mismatch and structural change. A better role for govt. is to reduce regulations, etc. •Hawks at the Fed argue this point today.
12Money in the classical model; nonneutrality and reverse causation•Because prices adjust rapidly to restore equilibrium, money is neutral in short and long-runs.•Nonneutrality and reverse causality: But if money is neutral, why does the data indicate money is a leading, procyclical variable?•Classical answer is reverse causality. Just because changes in the money supply precede changes in output does not mean that the money changes cause output changes (example of storm window installation in advance of winter does not mean storm window installation causes winter).•Reserve causation means money growth is higher because people expect higher output in the future. Higher money growth does not cause higher future output. If so, money can be procyclical and leading even though money is neutral. Firms, anticipating higher sales, would need more money for transactions to pay for materials and workers. The need for higher transactions balances means that a forward thinking Fed trying to maintain stable prices would provide an increase in the money (supply) to meet increased demand. Otherwise the price level would have to decline to increase the real money supply.•Empirical evidence on non-neutrality: money is nonneutral.•Friedman-Schwartz: Disputes reverse causation and argued for the nonneutrality of money. Often monetary changes have had an independent origin. They were not just a reflection of changes or future changes in economic activity. These independent changes were followed by changes in income and prices. Independent changes of money include gold discoveries, changes in financial institutions, and changes in Fed leadership.•Romer/Romer: Extended Friedman-Schwartz and found that money was also nonneutral. They emphasized the 1979 tight money policy and subsequent 1982 loose money policy as nonneutral events. The first was followed by a severe recession and second by a boom.
13Misperceptions and the nonneutrality of money •While money does not appear to be neutral, there is a version of the classical model that can explain why money is not neutral-the misperceptions theory.•Classical model: In the classical model, money is neutral because prices adjust quickly. The only relevant supply curve is the long-run supply curve (LRAS) which is vertical. With a vertical LRAS, movements in aggregate demand only change prices, they have no effect on output.