economics_of_money_banking__financial_markets

www.whitehouse.gov/fsbr /esbr.html

The White House sponsors an economic statistics briefing room that reports a wide variety of interesting data dealing with the state of the economy.

One group, led by Edward Prescott of the University of Minnesota, has developed a theory of aggregate economic fluctuations called real business cycle theory, in which aggregate supply (real) shocks do affect the natural rate level of output Yn. This theory views shocks to tastes (workersÕ willingness to work, for example) and technology (productivity) as the major driving forces behind short-run fluctuations in the business cycle, because these shocks lead to substantial short-run fluctuations in Yn. Shifts in the aggregate demand curve, perhaps as a result of changes in monetary policy, by contrast are not viewed as being particularly important to aggregate output fluctuations. Because real business cycle theory views most business cycle fluctuations as resulting from fluctuations in the natural rate level of output, it does not see much need for activist policy to eliminate high unemployment. Real business cycle theory is highly controversial and is the subject of intensive research.5

Another group of economists disagrees with the assumption that the natural rate level of output Yn is unaffected by aggregate demand shocks. These economists contend that the natural rate level of unemployment and output are subject to hysteresis, a departure from full employment levels as a result of past high unemployment.6 When unemployment rises because of a reduction of aggregate demand that shifts the AD curve inward, the natural rate of unemployment is viewed as rising above the full employment level. This could occur because the unemployed become discouraged and fail to look hard for work or because employers may be reluctant to hire workers who have been unemployed for a long time, seeing it as a signal that the worker is undesirable. The outcome is that the natural rate of unemployment shifts upward after unemployment has become high, and Yn falls below the full employment level. In this situation, the self-correcting mechanism will be able to return the economy only to the natural rate levels of output and unemployment, not to the full employment level. Only with expansionary policy to shift the aggregate demand curve to the right and raise aggregate output can the natural rate of unemployment be lowered (Yn raised) to the full employment level. Proponents of hysteresis are thus more likely to promote activist, expansionary policies to restore the economy to full employment.

Conclusions

Aggregate demand and supply analysis yields the following conclusions (under the usual assumption that the natural rate level of output is unaffected by aggregate demand and supply shocks):

1. A shift in the aggregate demand curveÑwhich can be caused by changes in monetary policy (the money supply), fiscal policy (government spending or taxes),

5See Charles Plosser, ÒUnderstanding Real Business Cycles,Ó Journal of Economic Perspectives (1989): 51Ð77, for a nontechnical discussion of real business cycle theory.

6For a further discussion of hysteresis, see Olivier Blanchard and Lawrence Summers, ÒHysteresis in the European Unemployment Problem,Ó NBER Macroeconomics Annual, 1986, 1, ed. Stanley Fischer (Cambridge, Mass.: M.I.T. Press, 1986), pp. 15Ð78.

Vietnam War Buildup, 1964–1970

Negative Supply Shocks, 1973–1975 and 1978–1980

Aggregate supply and demand analysis is an extremely useful tool for analyzing aggregate economic activity; we will apply it to several business cycle episodes. To simplify our analysis, we always assume in all three examples that aggregate output is initially at the natural rate level.

AmericaÕs involvement in Vietnam began to escalate in the early 1960s, and after 1964, the United States was fighting a full-scale war. Beginning in 1965, the resulting increases in military expenditure raised government spending, while at the same time the Federal Reserve increased the rate of money growth in an attempt to keep interest rates from rising. What does aggregate supply and demand analysis suggest should have happened to aggregate output and the price level as a result of the Vietnam War buildup?

The rise in government spending and the higher rate of money growth would shift the aggregate demand curve to the right (shown in Figure 5). As a result, aggregate output would rise, unemployment would fall, and the price level would rise. Table 3 demonstrates that this is exactly what happened: The unemployment rate fell steadily from 1964 to 1969, remaining well below what economists now think was the natural rate of unemployment during that period (around 5%), and inflation began to rise. As Figure 5 predicts, unemployment would eventually begin to return to the natural rate level because of the economyÕs self-correcting mechanism. This is exactly what we saw occurring in 1970, when the inflation rate rose even higher and unemployment increased.

In 1973, the U.S. economy was hit by a series of negative supply shocks. As a result of the oil embargo stemming from the Arab-Israeli war of 1973, the Organization of Petroleum Exporting Countries (OPEC) was able to engineer a quadrupling of oil prices by restricting oil production. In addition, a series of crop failures throughout the world led to a sharp increase in food prices. Another factor was the termination of wage and price controls in 1973 and 1974, which led to a push by workers to obtain wage increases that had been prevented by the controls. The triple thrust of these events caused the aggregate supply curve to shift sharply leftward, and as the aggregate demand and

Favorable Supply Shocks, 1995–1999

supply diagram in Figure 6 predicts, both the price level and unemployment began to rise dramatically (see Table 4).

The 1978Ð1980 period was almost an exact replay of the 1973Ð1975 period. By 1978, the economy had just about fully recovered from the 1973Ð1974 supply shocks, when poor harvests and a doubling of oil prices (as a result of the overthrow of the Shah of Iran) again led to another sharp leftward shift of the aggregate supply curve. The pattern predicted by Figure 6 played itself out againÑinflation and unemployment both shot upward (see Table 4).

In February 1994, the Federal Reserve began to raise interest rates, because it believed the economy would be reaching the natural rate of output and unemployment in 1995 and might become overheated thereafter. As we can see in Table 5, however, the economy continued to grow rapidly, with unem-

Summary

1.The aggregate demand curve indicates the quantity of aggregate output demanded at each price level, and it is downward-sloping. Monetarists view changes in the money supply as the primary source of shifts in the aggregate demand curve. Keynesians believe that not only are changes in the money supply important to shifts in the aggregate demand curve, but so are changes in fiscal policy (government spending and taxes), net exports, and the willingness of consumers and businesses to spend (Òanimal spiritsÓ).

2.In the short run, the aggregate supply curve slopes upward, because a rise in the price level raises the profit earned on each unit of production, and the quantity of output supplied rises. Four factors can cause the

aggregate supply curve to shift: tightness of the labor market as represented by unemployment relative to the natural rate, expectations of inflation, workersÕ attempts to push up their real wages, and supply shocks unrelated to wages that affect production costs.

3.Equilibrium in the short run occurs at the point where the aggregate demand curve intersects the aggregate supply curve. Although this is where the economy heads temporarily, it has a self-correcting mechanism, which leads it to settle permanently at the long-run equilibrium where aggregate output is at its natural rate level. Shifts in either the aggregate demand or the aggregate supply curve can produce changes in aggregate output and the price level.

activists, p. 592 aggregate demand, p. 582

aggregate demand curve, p. 582 aggregate supply, p. 582 aggregate supply curve, p. 588 Òanimal spirits,Ó p. 586 complete crowding out, p. 587 consumer expenditure, p. 585 equation of exchange, p. 583 government spending, p. 585

QUIZ Questions and Problems

hysteresis, p. 597

Keynesians, p. 582

long-run aggregate supply curve, p. 590

modern quantity theory of money, p. 584

monetarists, p. 582

natural rate level of output, p. 590

natural rate of unemployment, p. 590

net exports, p. 585

nonaccelerating inflation rate of unemployment (NAIRU), p. 590

nonactivists, p. 592

partial crowding out, p. 587

planned investment spending, p. 585

real business cycle theory, p. 597

self-correcting mechanism, p. 591

supply shocks, p. 594

velocity of money, p. 582

Questions marked with an asterisk are answered at the end of the book in an appendix, ÒAnswers to Selected Questions and Problems.Ó

1.Given that a monetarist predicts velocity to be 5, graph the aggregate demand curve that results if the money supply is $400 billion. If the money supply falls to $50 billion, what happens to the position of the aggregate demand curve?

*2. Milton Friedman states, ÒMoney is all that matters to nominal income.Ó How is this statement built into the aggregate demand curve in the monetarist framework?

3.Suppose that government spending is raised at the same time that the money supply is lowered. What will happen to the position of the Keynesian aggregate demand curve? The monetarist aggregate demand curve?

*4. Why does the Keynesian aggregate demand curve shift when Òanimal spiritsÓ change, but the monetarist aggregate demand curve does not?

5.If the dollar increases in value relative to foreign currencies so that foreign goods become cheaper in the United States, what will happen to the position of the aggregate supply curve? The aggregate demand curve?

*6. ÒProfit-maximizing behavior on the part of firms explains why the aggregate supply curve is upwardsloping.Ó Is this statement true, false, or uncertain? Explain your answer.

7.If huge budget deficits cause the public to think that there will be higher inflation in the future, what is likely to happen to the aggregate supply curve when budget deficits rise?

*8. If a pill were invented that made workers twice as productive but their wages did not change, what would happen to the position of the aggregate supply curve?

9.When aggregate output is below the natural rate level, what will happen to the price level over time if the aggregate demand curve remains unchanged? Why?

*10. Show how aggregate supply and demand analysis can explain why both aggregate output and the price level fell sharply when investment spending collapsed during the Great Depression.

11.ÒAn important difference between monetarists and Keynesians rests on how long they think the long run actually is.Ó Is this statement true, false, or uncertain? Explain your answer.

Using Economic Analysis to Predict the Future

*12. Predict what will happen to aggregate output and the price level if the Federal Reserve increases the money supply at the same time that Congress implements an income tax cut.

13.Suppose that the public believes that a newly announced anti-inflation program will work and so lowers its expectations of future inflation. What will

602 P A R T V I Monetary Theory

happen to aggregate output and the price level in the short run?

*14. Proposals have come before Congress that advocate the implementation of a national sales tax. Predict the effect of such a tax on both the aggregate supply and demand curves and on aggregate output and the price level.

15.When there is a decline in the value of the dollar, some experts expect this to lead to a dramatic improvement in the ability of American firms to compete abroad. Predict what would happen to output and the price level in the United States as a result.

Web Exercises

1.As this book goes to press, the U.S. economy is still suffering from slow growth and relatively high unemployment. Go to www.whitehouse.gov/fsbr/esbr.html and follow the link to unemployment statistics. What has happened to unemployment since the last reported figure in Table 5?

2.As the economy stalled toward the end of 2002, Fed policymakers were beginning to be concerned about deflation. Go to www.whitehouse.gov/fsbr/esbr.html and follow the link to prices. What has happened to prices since the last reported figure in Table 5? Does deflation still appear to be a threat?

ap pendi x

to chap ter

25

Aggregate Supply and

the Phillips Curve

In this appendix, we examine how economistsÕ view of aggregate supply has evolved over time and how the concept called the Phillips curve, which described the relationship between unemployment and inflation, fits into the analysis of aggregate supply.

The classical economists, who predated Keynes, believed that wages and prices were extremely flexible, so the economy would always adjust quickly to the natural rate level of output Yn. This view is equivalent to assuming that the aggregate supply curve is vertical at an output level of Yn even in the short run.

With the advent of the Great Depression in 1929 and the subsequent long period of high unemployment, the classical view of an economy that adjusts quickly to the natural rate level of output became less tenable. The teachings of John Maynard Keynes emerged as the dominant way of thinking about the determination of aggregate output, and the view that aggregate supply is vertical was abandoned. Instead, Keynesians in the 1930s, 1940s, and 1950s assumed that for all practical purposes, the price level could be treated as fixed. They viewed aggregate supply as a horizontal curve along which aggregate output could increase without an increase in the price level.

In 1958, A. W. Phillips published a famous paper that outlined a relationship between unemployment and inflation.1 This relationship was popularized by Paul Samuelson and Robert Solow of the Massachusetts Institute of Technology in the early 1960s, and naturally enough, it became known as the Phillips curve, after its discoverer. The Phillips curve indicates that the rate of change of wages w/w, called wage inflation, is negatively related to the difference between the actual unemployment rate U and the natural rate of unemployment Un:

w/w h(U Un)

where h is a constant that indicates how much wage inflation changes for a given change in U Un. If h were 2, for example, a 1 percent increase in the unemployment rate relative to the natural rate would result in a 2 percent decline in wage inflation.

The Phillips curve provides a view of aggregate supply because it indicates that a rise in aggregate output that lowers the unemployment rate will raise wage inflation and thus lead to a higher level of wages and the price level. In other words, the Phillips curve implies that the aggregate supply curve will be upward-sloping. In addition, it indicates that when U > Un (the labor market is slack), w/w is negative

1A. W. Phillips, ÒThe Relationship Between Unemployment and the Rate of Change of Money Wages in the United Kingdom, 1861Ð1957,Ó Economica 25 (1958): 283Ð299.