# AS/AD Model part 2 - Northern Arizona University

Monetary Theory: The AD/AS Model Pt. II ECO 473 Money & Banking Dr. D. Foster AS/AD Model Hints at 4 types of changes: P ASLR Inflation with growth due to rising AD. AS Depression with deflation due to falling AD. 1 Growth with deflation due

to rising AS. Depression with inflation due to falling AS. (stagflation) P1 AD 1 Q* Q or R- The Transmission Mechanism of Monetary Policy Fed buys bonds.

Bank reserves rise, as do their excess reserves. The money supply expands. Interest rates fall to equate MS with MD. Investment spending rises. Income rises. And, if the Fed sells bonds TheTransmission Transmission Mechanism of Monetary Policy The Mechanism of Monetary Policy Assume: money multiplier is 2.5

interest rates change by 1% per \$80b MSMS investment changes by \$35b per 1% MSr income rises \$5 for each \$1 increase in spending How much will income change by if the Fed buys \$10 billion worth of bonds? Change in the monetary base = +\$10 billion Change in the money supply = +\$25 billionby if the Fed How much will income change Change in interest ratesworth = -0.3125% sells \$15 billion of bonds?

Change in investment = +\$10.9 billion Change in income = +\$54.7 billion Are Monetary Policies Effective? In the Short Run only: If they are unexpected. If wage/price rigidities persist. Over time, these should be less likely. How effective? The liquidity effect How responsive are interest rates to changes in the money supply? [i is 3% ] The interest elasticity of investment How responsive is investment to a change in interest rates? [I is \$50 b. ] Velocity of M1: 1970 - 2018 2018 Q4: 5.61

Velocity of M2: 1970 - 2018 2018 Q4: 1.459 Velocity of MZM: 1970 - 2018 2018 Q4: 1.335 Monetarist vs. Keynesian What are the initial causes of a recession? Money Supply Investment The Fed as source.

Lack of animal spirits. How fast can the economy recover? Very fast. Not very fast. Govt as source of disruption. Market instability. Markets are quite robust. May have long-term unemployment problem. How does monetary policy help? It has a direct effect on consumer spending. Works through effects on

investment spending. Very powerful. Likely ineffective. Pushing on a string. Monetarist vs. Keynesian Should the government aid in the recovery from recession? No. Yes. Use rules. Use discretion. Monetary rules will provide the necessary effect.

Fiscal policies, especially govt spending are best. What about increase both government spending and taxes, to maintain a balanced budget? Government spending has dubious effects. Government spending is the key to success. Taxes will slow down economic growth. Taxes will be more than offset by govt spending. Keynesian vs. Monetarist & the SR AS P

ASLR AS Monetarist AS Keynes P1 AD AD 2 Q* Q or 1 R- The AS is flat in

the Keynesian view and steep according to the Monetarists. So, a decrease in the AD will have different consequences in the two theories. Persistent inflation & inflationary expectations P AS4 AS5 AS3 The Fed tries to reduce unemployment and increase output by

MS. This AD. With a lag, the AS will decrease so all we see is P. The Fed keeps trying, but now no lag in AS. AS2 AS1 P4 P3 P2 P1 AD AD2 AD2 1 Q*

Q or R- If the Fed stops inflationary expectations will continue to AS, now Q. Can we eliminate inflation by AS (short run)? No, these policies are doomed to failure. Remember, inflation is a monetary phenomenon, and caused by shifts in the AD. So, what are these policies? Wage & price controls

Tax-based Incomes policies (TIPs) Supply-side incentives to boost output. Remove barriers that keep wages/prices from falling. To eliminate inflation we must AD But, well have to contend with inflationary expectations. How? Gradualism approach Going cold turkey Indexing Wages, mortgage interest rates, taxes And, what of the role of government? Increasing share of GDP & growth is slower, recoveries taking longer. Benefits of G may not be worth the costs. Current Problems & Policy Questions Prices Decreased AD sends us into

recession. Fed expands the MS to stimulate economic growth. Doesnt work. ASLR ASSR P3 AD P1 Eventually, theres an overreaction. AD P2 AD

AD Q Q* Q = Real GDP Sharply rising AD leads to high levels of inflation. What will be the Was effect of the Obama Feds havingaMB to Keynesian? \$4 tr and ER

Worksheet: Monetary Transmission Mechanism Where we have the following information: The money multiplier is 3.25, or is derived from the formula. Interest rates will change by 1.5% for each \$65 billion change in the money supply. Investment will change by \$122 billion for each 2% change in interest rates. Income will change by \$7 for each \$2 change in investment. The unemployment rate will change by .46% for each \$150 billion change in income, up to a maximum change of +1.84%. If the change in income exceeds +\$600 billion, the effects will be strictly inflationary (if income rises) or deflationary (if income falls). For each additional \$150 Worksheet: Monetary Transmission Mechanism

1. What will be the impact on income, unemployment and inflation if the Fed buys \$15 billion worth of bonds? 2. What will be the impact on income, unemployment and inflation if the Fed sells \$25 billion worth of bonds? 3. If the Fed wants to raise income by \$350 billion, how much should it buy/sell in Treasury bonds? 4. If the Fed wants to lower the unemployment rate by 1%, how much should it buy/sell in Treasury bonds? Monetary Theory: The AD/AS Model Pt. II ECO 473 Money & Banking Dr. D. Foster

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