26
CHAPTER
Web Site Suggestions:
http://www.gpoaccess.
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Presents data on
money and output
movements tracked
by the Council of
Economic Advisers’
Monthly Economic
Indicators.
Money and Output
in the Short Run
A group of business executives gathered for a dinner in 2001 at New York’s WaldorfAstoria Hotel to hear a speech entitled “Monetary Policy and the New World Order”
given by a respected member of the Fed’s Board of Governors. The speech followed
major changes in monetary policy in the 1980s and 1990s, and the question and
answer period was lively: “You can talk about long-run adjustments,” an angry CEO
whose firm had suffered losses and layoffs in the incipient recession said to the speaker,
“but answer this: Why does a fall in the money supply put people out of work?”
During recessions, output declines. As firms experience a decrease in demand, they
may lay off workers, increasing unemployment. Recessions are troublesome to both individuals and businesses. Unemployed individuals experience economic hardship, loss of
self-esteem, and erosion of their skills. During a downturn, businesses lose profits and
may fail. Could the Fed intervene to reduce the severity of downturns? Should it?
In this chapter, we examine changes over time in the money supply and output to
find out whether there is a link between these two variables. In the first section, we
present the evidence that economists study to determine whether there is a link between
the money supply and output. Economists differ in their interpretations of the evidence,
and as a result, they propose different explanations for the reasons that output may (or
may not) vary with changes in the money supply. We then describe the explanations for
the patterns proposed by three groups of economists: real business cycle economists,
new classical economists, and new Keynesian economists. On the basis of these explanations, we describe how monetary policy might alleviate the severity of economic
downturns. We conclude with an analysis of policy enacted during the 1980s, 1990s,
and early 2000s.
Tracking Money and Output Movements
in the Short Run
Although the money supply and output have grown steadily over long periods of time,
both of these economic variables fluctuate over the short run as the economy moves
through the business cycle. During the business cycle, output grows during an expansion or a boom until it reaches a peak. Then it declines as the economy moves into a
contraction or recession until it reaches a trough. This pattern varies from several
months to several years, and expansions and recessions vary in intensity. Business cycles
have existed since the Industrial Revolution and have been analyzed by economists
since the nineteenth century. Figure 26.1 shows periods of contraction—recessions—
from 1950 to the present.
The growth of the money supply also varies over the business cycle, as Fig. 26.1
shows. Movements in the growth rate of the money supply are procyclical; that is, the
growth rate generally increases during expansions and decreases during recessions. In
studying data such as those presented in Fig. 26.1, economists have found that changes
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in the nominal money supply often precede the fluctuations in output that occur during the business cycle; that is, monetary expansions often precede business cycle peaks,
and monetary contractions often precede business cycle troughs.
How do economists interpret this pattern of changes in the money supply with
output? There is no single answer because these changes can be explained differently.
For example, some economists contend that changes in the money supply are responsible for subsequent changes in output, whereas others believe that changes in the
money supply reflect, rather than cause, changes in output. In the next three sections,
we use the aggregate demand–aggregate supply model that we built in Chapter 25 to
study the explanations of the pattern shown in Fig. 26.1. Specifically, we look at the
views of real business cycle economists, new classical economists, and new Keynesian
economists. We then turn to the policy recommendations of each to see how and
whether the Fed might try to reduce the severity of declines in output during recessions.
The Real Business Cycle Model
FIGURE 26.1
Money Supply Growth and
the Business Cycle,
1950–2002
Data are for M1 growth at
an annual percentage rate. The
shaded areas represent recessions designated by the National
Bureau of Economic Research, a
private economic research organization responsible for dating U.S.
business cycles.
Source: Federal Reserve Bulletin.
Money growth (annual rate, %)
In the long run, prices are flexible; that is, firms adjust their prices to match changes in
cost or demand. When prices are flexible, the nominal money supply has no impact on
the level of economic activity; therefore money is neutral. One-time increases or
decreases in the nominal money supply affect the price level but not real output.
The real business cycle model holds that prices are flexible even in the short run
and that output is at the full employment level in the economy’s short-run equilibrium.
Hence the economy’s short-run aggregate supply curve, SRAS, is vertical. But actual
output fluctuates over time. The real business cycle model says that the observed fluctuations in output in the short run primarily are caused by temporary shocks to productivity. These shocks include shifts in the availability of key raw materials (food,
energy, and minerals, for example), regulatory restrictions on production or markets,
and innovations that make the economy more productive.
The real business cycle model also holds that increases or decreases in the money
supply have no effect on economic activity, even in the short run. In Fig. 26.1, it
25.0
20.0
15.0
M1
10.0
5.0
0.0
–5.0
–10.0
1950
1955
1960
1965
1970
1975
1980
1985
1990
1995
2000 2002
Year
CHAPTER 26
Money and Output in the Short Run
613
appears that the money supply grows more rapidly before and during expansions than
it does during contractions. Does this pattern necessarily contradict the assumption
that money is neutral? Proponents of the real business cycle model answer no, arguing
that even though the money supply and output move together, changes in the money
supply don’t necessarily cause changes in output. Specifically, proponents of the real
business cycle model offer two arguments against a causal relationship between the
money supply and output. First, they suggest that some other variable might be responsible for the shifts in money supply and output. Second, they propose that changes in
output might cause changes in the money supply. This second argument is an example
of a type of reasoning called reverse causation.
The second argument is used more often than the first by the real business cycle
economists, who argue that current and anticipated future changes in output affect the
demand for money rather than the supply of money. To demonstrate, suppose that the
economy experiences a boom brought on by a favorable productivity shock, such as a
temporary decline in oil prices. Anticipating a future increase in income, households
and businesses demand more currency and checkable deposits because of greater
demand for money for transactions. The increase in demand for money resulting from
the rise in output and the boom causes the Fed passively to increase the money supply.
Thus real business cycle advocates argue that changes in output increase the money
supply, rather than that a change in the money supply affects output—a classic example of reverse causation. These economists present a view that is at one pole of our
analysis: There is no causal link from the money supply to output. The other schools
of thought do believe that there is a causal link, and they cite evidence against reverse
causation.
To test the link between the money supply and output, Milton Friedman (then of
the University of Chicago, now at Stanford University) and Anna Schwartz (of the
National Bureau of Economic Research) examined the historical pattern between these
two variables. They found that the money supply growth rate fell before each decline in
output.✝ This pattern held for every recession for the period studied, almost 100 years.
Friedman and Schwartz documented that the peak in the nominal money supply growth
rate precedes the peak in output on average by 16 months. This time period was not
constant for all business cycles; it ranged from a few months to more than two years.
On the basis of their examination of many business cycles in the period between the
Civil War and 1960, Friedman and Schwartz concluded that changes in money growth
cause output fluctuations. They also concluded, however, that money’s effects on output
appeared only after long and variable lags.
The test of Friedman and Schwartz’s assertion is whether the changes in the money
supply that they identified were “independent.” An independent change in the money
supply is one that is not influenced by a change in output or by some third factor that
influenced both money and output.
Independent events can also be Fed policies that are designed to achieve objectives
other than increases in output. By tracing the impact of an independent change, we can
draw conclusions about how changes in the money supply affect output in the short run.
Friedman and Schwartz studied specific historical episodes that fit the description of
independent events: the banking panics prior to the founding of the Federal Reserve System, the wave of bank failures during the early 1930s, and the increases in reserve
✝ Milton
Friedman and Anna J. Schwartz, A Monetary History of the United States. Princeton, N.J.: Princeton University Press, 1963.
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requirements in 1936 and 1937. They associated the decline in the money supply during
banking panics, such as the panic of 1907, when the public converted bank deposits into
currency, with the subsequent decline in economic activity caused by deposit contraction
and reduction of money growth. The wave of bank failures during the early 1930s significantly reduced the money supply, and Friedman and Schwartz blamed the loss of output during the early 1930s on this “Great Contraction.” They also traced the
pronounced recession of 1937–1938 to the monetary contraction resulting from the
Fed’s increase in the required reserve ratio, which reduced the money supply. The change
in reserve requirements was independent because it was associated with the Fed’s desire
to increase its control over the money supply, not with a policy to influence the current
level of economic activity. All these episodes show linkage from a change in money supply growth to a change in the level of output. In this spirit, Christina Romer and David
Romer of the University of California, Berkeley, identified six independent monetary policy shifts after 1960 in which the FOMC announced a contractionary monetary policy
to fight inflation.✝ Each episode was followed by a decline in output. They maintain that
because the monetary contractions were intended to reduce inflation, they are independent of current output conditions.
Another way to explore whether changes in money growth cause changes in output is to study more continuous measures of the extent to which monetary policy is
likely to increase or decrease output. By means of statistical tests, Ben Bernanke, now
a Fed governor, and Alan Blinder of Princeton University documented that increases
in the federal funds rate cause output to fall.✝✝ They argue that changes in the federal
funds rate are independent since they are determined largely by actions of the Fed.
These findings confirm that the money supply declines almost immediately in response
to a contractionary policy by the Fed and that output declines with a lag of between
six months and one year. Therefore the evidence on money and output movements
doesn’t support the basic real business cycle model; in the short run, money appears
not to be neutral.
Although the real business cycle model provides an accurate view of the long run,
in which prices are flexible and money is neutral, its predictions for the short run are
not consistent with historical evidence. Two other schools of thought—the new classical school and the new Keynesian school—develop the idea that money and output are
related. They offer different explanations for the link, as described next.
C H E C K P O I N T
During the fourth quarter of each year, especially in the month of December,
measures of money and retail sales are higher than they are during the rest of the
year. Do these temporary changes mean that the increase in the money supply
caused the change in output? Real business cycle economists note that a more
likely explanation is that the demand for goods rises for the holiday season, increasing the public’s demand for currency and checkable deposits. The Fed smooths the
surge in money demand by increasing the money supply to satisfy the demands of
households and businesses.♦
✝ Christina
Romer and David Romer, “Does Monetary Policy Matter?: A New Test in the Spirit of Friedman
and Schwartz,” in O. J. Blanchard and S. Fischer, eds., NBER Macroeconomics Annual. Cambridge, Mass.:
MIT Press, 1989, pp. 121–170.
✝✝ Ben
S. Bernanke and Alan S. Blinder, “The Federal Funds Rate and the Channels of Monetary Transmission,” American Economic Review, 82:901–921, 1992.
CHAPTER 26
Money and Output in the Short Run
615
Money and Output: The New Classical Model
New classical economists attribute the link between the money supply and output to
imperfect information. Specifically, they believe that firms do not completely adjust
their prices and workers do not adjust their wages in the short run because business
managers and workers have imperfect information about changes in the price level.
Inflexible prices prevent money from being neutral in the short run. In the new classical view, output increases when the price level is higher than expected. Households
and businesses incorporate expectations of changes in the money supply into their
forecasts of the aggregate price level. Expected increases in the money supply raise
households’ and firms’ expected value of the price level, and expected decreases in the
money supply reduce the expected value of the price level. According to new classical
economists, the impact of changes in the nominal money supply on output in the short
run depends on whether those changes are expected or unexpected.
To understand the distinction
between expected and unexpected changes in the nominal money supply, suppose that
the economy is in equilibrium and that the Fed announces a 10% increase in the nominal money supply. This announcement becomes part of the information that households and businesses use in forecasting the aggregate price level. We illustrate the
impact on output using the AD-AS diagram. Starting from the economy’s equilibrium
at E0 in Fig. 26.2(a), a one-time expected increase in the nominal money supply shifts
the aggregate demand curve from AD0 to AD1 and increases the expected price level,
thereby shifting the short-run aggregate supply curve up from SRAS0 to SRAS1. The
economy’s new short-run equilibrium has a higher price level, P1, but output doesn’t
change. In this case, households and businesses expect the price level to increase
because of the expected increase in the money supply. Hence they are not surprised
when the price level does increase, and so real output is not affected. Therefore new
classical economists conclude that a perfectly anticipated change in the money supply
has no effect on real output, and changes in the money supply are neutral.
Expected changes in the money supply.
What if an increase in the money
supply is unexpected? For example, suppose that the Fed surprises households and
businesses by suddenly increasing the money supply by 10%. In Fig. 26.2(b), from an
initial equilibrium at E0, the monetary expansion shifts the aggregate demand curve to
the right from AD0 to AD1. The expected price level doesn’t change, so the short-run
aggregate supply curve remains at SRAS0. At the new equilibrium, E1, output has risen
from Y0 to Y1, and the actual price level has risen from P0 to P1. Because the actual
price level exceeds the expected price level, firms are fooled into thinking that the relative prices of their products have increased. Therefore they increase their output. An
unanticipated change in the money supply is not neutral because output increases in
response to an unexpected increase in the nominal money supply and decreases in
response to an unexpected decrease.
New classical economists have examined whether unexpected and expected
changes in the money supply have different effects on output or prices. They haven’t
arrived at a consensus, but the available evidence suggests that both expected and
unexpected changes in the nominal money supply affect current output. This evidence
is inconsistent with the new classical view. New Keynesian economists have tried to
explain this evidence while retaining the sensible assumption of the new classical
Unexpected changes in the money supply.
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PART 6
FIGURE 26.2
The Financial System and the Macroeconomy
Money and Output Changes in the New Classical Model
In the new classical model, only unexpected changes in the money supply affect output in the short run.
As shown in (a):
1. From an initial equilibrium at E0 , an expected increase in the nominal money supply shifts the AD curve from AD0 to AD1.
2. The expected price level increases, shifting the SRAS curve from SRAS0 to SRAS1.
3. At the new equilibrium, E1 , the price level rises to P1 , and output remains unchanged at Y0.
2. Expected price
level rises.
SRAS1
SRAS 0
SRAS0
Price level, P
Price level, P
As shown in (b):
1. From an initial equilibrium at E0, an unexpected increase in the nominal money supply shifts the AD curve from AD0 to AD1.
2. At the new equilibrium, E 1 , the price level rises to P1 , and output rises to Y1.
E1
E1
P1
P1
1. Money
supply rises.
P0
E0
3. Price level
rises, but output
is unchanged.
1. Money
supply rises.
E0
P0
2. Output and
price levels
rise.
AD1
AD1
AD0
AD0
Y0 Current output, Y
(a) Expected Increase in the Money Supply
Y0
Y1 Current output, Y
(b) Unexpected Increase in the Money Supply
approach that households and businesses use available information in forming their
expectation of money growth or the price level.
C H E C K P O I N T
Suppose that you knew that the aggregate price level was closely correlated with
the size of the money supply and that you could observe the size of the money
supply continuously. Would the misperception theory be useful in explaining the
business cycle? Why or why not? No. Because you can observe the money supply
continuously, there would be no misperception. ♦
Money and Output: The New Keynesian Model
New Keynesian economists link output movements to changes in the money supply by
arguing that prices are not completely flexible. The new Keynesians propose two reasons for price stickiness in the short run: long-term contracts and imperfect competition among sellers in the goods market.
According to new Keynesians, neither expected nor unexpected changes in the nominal money supply are neutral in the short run. Figure 26.3(a) illustrates the effect of an
unexpected decline in the money supply. Suppose that the Fed announces a reduction of
CHAPTER 26
FIGURE 26.3
Money and Output in the Short Run
617
Money and Output in the New Keynesian Model
Money is not neutral in the short run in the new Keynesian view.
As shown in (a):
1. From an initial equilibrium E0 , a monetary contraction shifts the AD curve from AD0 to AD1.
2. Because the decline in the money supply is unexpected, the SRAS curve remains at SRAS0. At the new equilibrium E1 , output has fallen
from Y0 to Y1.
1. Money
supply falls.
SRAS 0
Price level, P
Price level, P
As shown in (b):
1. From an initial equilibrium E0 , a monetary contraction shifts the AD curve from AD0 to AD1.
2. Because the decline in the money supply is expected, the expected price level falls, and some but not all prices fall. The SRAS curve shifts
from SRAS0 to SRAS1.
3. At the new equilibrium, E1 , output has fallen from Y0 to Y1 , which is greater than Y1 in (a).
1. Money
supply falls.
2. Expected price
level falls.
SRAS 0
SRAS 1
E0
E0
E1
E1
AD0
2. Output
falls.
AD0
3. Output
falls.
AD1
Y1
Y0 Current output, Y
(a) Unexpected Decrease in the Money Supply
AD1
Y1
Y0
Current output, Y
(b) Expected Decrease in the Money Supply
the money supply that was not anticipated by households and firms. From an initial
equilibrium at E0, the monetary contraction shifts the AD curve to the left from AD0
to AD1. The contraction was unexpected, so prices do not adjust downward, and the
SRAS curve remains at SRAS0. The new equilibrium lies at E1, the intersection of the
AD1 and SRAS0 curves. Because aggregate supply doesn’t adjust in the short run, output falls from Y0 to Y1. This pattern closely resembles that proposed by the new classical economists.
Now let’s consider the case of an expected monetary contraction. New Keynesians
believe that households and businesses use all available information to forecast demand
and the price level. Hence, when the money supply is expected to fall, the expected price
level also should fall. Firms with flexible prices—prices that can be changed in the current
period—lower their prices, as in the new classical explanation. However, many prices do
not adjust in the current period, so the aggregate price level falls slowly in response to the
expected decline in the nominal money supply. Similarly, if firms are monopolistically
competitive and prices are costly to adjust, prices will adjust only gradually in response
to an anticipated change in the money supply.
Figure 26.3(b) illustrates the effect on output of an expected decrease in the money
supply. Starting from the economy’s equilibrium at E0, the drop in the money supply
shifts the aggregate demand curve to the left from AD0 to AD1. In this case, some prices
can and do adjust by falling in the short run. The short-run aggregate supply curve
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The Financial System and the Macroeconomy
shifts downward from SRAS0 to SRAS1. At the new equilibrium E1, however, output is
lower than at E0, so the price level hasn’t completely adjusted. This drop in output isn’t
as large as that in the case of an unexpected decrease in the money supply, depicted in
Fig. 26.3(a). In the new Keynesian model, even expected changes in the nominal money
supply can have real effects in the short run, although those effects are smaller than the
effects of an unexpected change.
New Keynesians believe that the money supply affects output by influencing the
determinants of aggregate demand through changes in interest rates. Because the price
level adjusts gradually to a change in the money supply, an increase in the nominal
money supply raises real money balances in the short run. To induce households and
firms to hold greater real money balances, the market-clearing real interest rate falls. A
drop in the nominal money supply reduces real money balances in the short run. To
restore equilibrium, the real interest rate must rise. These interest rate movements affect
aggregate demand by influencing investment, consumption, and net exports, as the case
study explains.
C H E C K P O I N T
You are a new Keynesian and chairman of the Federal Reserve Board. Your staff
tells you that a decline in business optimism has reduced desired investment and
aggregate demand. How could you use monetary policy to restore the level of
aggregate demand? The decline in business optimism shifts the AD curve to the left.
If you did not want to wait for the process of gradual price adjustment to restore the
economy’s equilibrium, you could use open market purchases to increase the nominal
money supply. Because the price level adjusts gradually, this change would increase
real money balances supplied, reducing the real interest rate and raising aggregate
demand (shifting the AD curve to the right). ♦
CONSIDER
THIS
...
Belgium, Finland, Germany, and the
Netherlands, the effect of a rise in
rates of output takes twice as long to
The sensitivity of key components of happen as in France, Italy, and Spain.
aggregate demand to interest rates The initial effect, however, is twice as
figures prominently in new Keynesian large in the latter group of countries.
analyses of effects of monetary policy
on the economy. Since January 1, Why the differences? Higher interest
1999, the 11 countries participating rates influence economies by raising
in the European monetary union have the cost of borrowing for investment,
shared a common short-term interest increasing debt-service burdens (and
rate. But do they share a common reducing spending), and pushing up
sensitivity of aggregate demand to the exchange rate (depressing exports). As a result, countries with
interest rates?
greater reliance on short-term borAs of 2003, the answer was no. Econ- rowing, weaker household and busiomists at the International Monetary ness balance sheets, and more
Fund have concluded that, within the important trade sectors are the most
European Monetary Union, in Austria,
Can One Size Fit All
in Europe?
exposed to interest rate changes in
the short run. Hence, when the European Central Bank tightens monetary
policy, the pain will be distributed
unevenly across member countries.
Over time, these differences should
become less important. With a common currency (the euro), for example, a
Europe-wide market for consumer
credit could both boost competition
and force banks to pass on changes in
interest rates more rapidly. This
convergence
will
not
happen
immediately, so that the European Central Bank’s task of judging the impact of
monetary policy is likely to be a difficult
one.
CHAPTER 26
CASE
Money and Output in the Short Run
619
STUDY
How Does Money Affect Aggregate
Demand in the New Keynesian View?
Suppose that the Fed increases the nominal money supply and that the price level adjusts gradually
as the new Keynesians predict. The real interest rate falls in the short run, affecting the cost of funds for
investment, stock prices, and exchange rates.
Interest Rates and Investment. A lower real interest rate reduces the opportunity cost of business
investment. Investment rises, increasing aggregate demand. Lower real interest rates also reduce the
cost to firms of carrying additional inventories, and firms therefore increase their inventory investment.
Thus, in the new Keynesian model, lower real interest rates lead to higher levels of current output by
lowering the cost of funds for business investment. Lower interest rates also reduce borrowing costs and
the opportunity cost of housing and consumer durable goods relative to owning financial assets, leading
to greater household investment in durable goods.
Stock Prices. Increases in the money supply cause investors to shift their portfolios, leading to higher
stock prices. There are two reasons for the rise in stock prices. The first is that higher money balances
encourage households and businesses to spend some of these balances on goods and assets, including
stocks. The higher demand for stocks raises their price. Second, all else being equal, interest rates fall
in response to an increase in the money supply. As interest rates decline, stocks become a more attractive investment relative to bonds. Thus, again, the increase in demand for stocks raises their price. In
either case, higher stock prices raise the market value of firms. Changes in stock prices affect both consumer and business spending. An increase in stock prices raises financial wealth (part of lifetime
resources) and therefore consumer spending. For business, higher stock prices signal improved profitability prospects. Firms often issue new shares, using the proceeds to buy new plant and equipment
and thereby increasing capital investment. When stock market valuation of firms is low, firms reduce
investment in new plant and equipment.
Exchange Rates. If the price level adjusts gradually in response to a monetary expansion, the real
interest rate that is available on domestic assets falls relative to rates on foreign assets. As a result,
global investors rebalance their portfolios to allocate more of their holdings to foreign assets and less to
domestic assets. The demand for U.S. dollars declines, so the value of the dollar relative to other currencies—the exchange rate—declines. The less valuable dollar makes U.S.-produced goods cheaper relative to foreign goods, stimulating exports from the United States and reducing imports to the United
States. The rise in net exports increases aggregate demand.
Should Public Policy Stabilize
Economic Fluctuations?
Public policies
designed to smooth
short-run fluctuations
in output involving
shifts of the AD curve
by changes in
government
purchases or taxes or
by changes in the
nominal money supply.
When the economy moves into the contractionary phase of the business cycle, output
declines and unemployment increases. These problems, as we have stated, cause hardship for individuals and businesses. We have also observed in the models that new classical economists and new Keynesian economists have proposed that increases in the
money supply can increase output. It may be possible, then, to develop monetary policies that could reduce the severity of recessions and smooth short-run fluctuations in
output. Such policies, known as stabilization policies, attempt to shift the AD curve by
changing the nominal money supply (monetary policy) or the level of government purchases or taxes (fiscal policy).
In this section, we extend our analysis of the link between the money supply and output to investigate whether we can use this relationship to improve economic conditions
in the short run. Once again, economists have differing views on the role of monetary
policies that are designed to change the money supply. They debate whether monetary
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policy is effective as stabilization policy because they differ in their opinion of the effect
of changes in the money supply on output and interest rates. On another level, they disagree as to whether monetary policy should be used to stabilize fluctuations. In this section, we consider the views of each school of thought and their policy recommendations.
The Real Business Cycle and New Classical Views
The real business cycle model places no value on policies that are intended to stabilize
economic fluctuations because it assumes that productivity disturbances cause fluctuations. Prices adjust quickly to these disturbances, so changes in the nominal money supply have no effect on current output or the real interest rate. Therefore economists who
favor the real business cycle model see no reason to implement stabilization policy.
New classical economists also are critical of stabilization policy. They stress that
only unexpected changes in policy have real effects. Their view is that the only way
public policy could smooth economic fluctuations is by confronting households and
businesses with surprise moves. In practice, they argue, such surprises are likely to
introduce substantial uncertainty in households’ and businesses’ decisions, leading to
random output fluctuations.
New classical economists assume that the public uses rational expectations in interpreting the effects of changes in economic variables such as the price level or changes
in the money supply. The rational expectations assumption does not mean that households and businesses can tell the future, only that people use all available information
in evaluating variables.✝ But they can make mistakes in their predictions. If households
and businesses form rational expectations about the price level, the actual price level will
be close to the expected price level on average. On average, the actual and expected
price levels are close, so the Fed gains little by using unexpected changes in the money
supply to stabilize output fluctuations. As a result, new classical economists recommend against stabilization policy.
The New Keynesian View
According to new Keynesian economists, upturns and downturns in economic activity
may represent times when the economy is not at its long-run equilibrium. These departures are particularly serious when output is below the full employment level because
recessions bring unemployment. The new Keynesians believe that shifts in aggregate
demand cause movements in current output. Therefore there may be a role for stabilization policy in reducing output fluctuations and especially recessions.
New Keynesians believe that expected and unexpected changes in monetary policy
affect current output and the real interest rate in the short run.✝✝ Because of sticky prices,
this link between the money supply and output exists even when the public uses rational
expectations to estimate the expected price level. Hence monetary policy could smooth out-
✝ In Chapter 10, we stated that the efficient markets hypothesis holds that asset prices increase or decrease
in response to the arrival of new information. For example, when analysts predict an increase in the price
of a share of Bigco, that information is incorporated into the share price because of rational expectations.
When the firm’s earnings are greater than is predicted by analysts, the price of the stock rises. Hence only
deviations from expectations change the price. This utilization of information and the reaction of prices to
new information are features of an efficient market. The efficient markets hypothesis is another application
of rational expectations.
✝✝ Fiscal
policy (changes in taxes or government purchases) also affects output in the short run in the new
Keynesian view. Here we analyze only monetary policy.
CHAPTER 26
Money and Output in the Short Run
621
put fluctuations. Let’s see how it might be done. Suppose that from an initial full employment equilibrium at E0 in Fig. 26.4(a), a decline in business confidence shifts the AD curve
to the left from AD0 to AD1. As a result, at E1, the economy is in a recession. Output falls
from Y* to Y1. With no policy intervention, the economy will eventually correct itself. In
other words, with output less than full employment at E1, prices will fall over time, shifting the SRAS curve down from SRAS0 to SRAS1, and restoring the initial level of output at
the economy’s equilibrium at E2. Economic activity eventually rebounds, but the possibly
long period of gradual price adjustment brings lost output and unemployment.
Alternatively, as Fig. 26.4(b) shows, the Fed could try to speed recovery by increasing the nominal money supply, shifting the AD curve back to the right from AD1 to
AD0. Because prices adjust only gradually, the expansionary policy moves the economy
from recession at E1 to its initial full employment equilibrium at E0 more quickly than
the “do nothing” alternative does. Stabilization policy, however, has a side effect: It
leads to a higher price level than would exist if no action were taken.
During the 1960s, many economists encouraged the use of monetary and fiscal policies to smooth fluctuations in the economy. However, others warned that there may be
long and variable lags in the policymaking and implementation process that make it difficult to fine-tune the economy. One such lag that is caused by the time needed to gather
data on economic variables is called a data lag. Gross domestic product (GDP) data for
a quarter are not published until several months later, although data on related variables
FIGURE 26.4
Effects of Activist Policy in the New Keynesian Model
As shown in (a):
1. From an initial full employment equilibrium at E0 , a decline in business confidence shifts the AD curve from AD0 to AD1 , and output falls
from Y * to Y1. At E1 , the economy is in a recession.
2. Over time, the price level adjusts downward, restoring the economy’s full employment equilibrium at E2.
1. Business confidence
falls, reducing AD.
SRAS0
SRAS 1
Price level, P
Price level, P
As shown in (b):
1. From an initial full employment equilibrium at E0 , a decline in business confidence shifts the AD curve from AD0 to AD1. At E1 , the economy
is in a recession.
2. The Fed speeds recovery by increasing the nominal money supply, which shifts the AD curve back from AD1 to AD0. Relative to the nonintervention case, the economy recovers more quickly (to E0) but with a higher long-run price level.
1. Business confidence
falls, reducing AD.
E0
E0
P0
P0
2. Price level
falls.
E1
SRAS0
2. Fed increases
nominal money
supply.
E1
P1
E2
AD0
AD0
AD1
AD1
Y1
Y* Current output, Y
(a) No Policy Intervention
Y1
Y*
Current output, Y
(b) Fed Responds
OTHER
PART 6
TIMES,
The Financial System and the Macroeconomy
OTHER
Yasushi Mieno and the
Stabilization Policy
Debate in Japan
In early 1992, Yasushi Mieno, then
the Governor of the Bank of Japan,
was feeling pressure. The Japanese
stock market had declined significantly, and the economy was heading
into its worst slowdown in almost 20
years. The Bank of Japan had reduced
the discount rate from 6% in the summer of 1991 to 4.5% six months later,
but business leaders lobbied Mieno to
pursue a more expansionary policy.
Some leading politicians even advised
Prime Minister Miyazawa to dismiss
the governor of the central bank.
Mieno essentially was pushed to conduct stabilization policy. Why did he
resist? Mieno and the Bank of Japan
believed that the Japanese economy
had overheated in the late 1980s and
early 1990s and that the stock market decline was just reversing an inflationary bubble. Using the AD-AS
diagram, we can trace this reasoning.
Mieno believed that the Japanese
economy was proceeding from a
short-run equilibrium at E0, at which
output Y0 was greater than long-run
PLACES
...
full employment output Y*, toward E1.
The declining stock market and falling
business confidence shifted the AD
curve to the left from AD0 to AD1.
If the Bank of Japan pursued an
expansionary policy in an attempt to
maintain output at Y0, in the short
run, the AD curve would shift to the
right from AD1 to AD0. However, to
achieve the economy’s long-run equilibrium—the intersection of the AD0
and LRAS curves at E3—the price level
must rise. Mieno’s strategy was to
await downward adjustment of the
price level as the SRAS curve shifted
from SRAS0 to SRAS1. With that strategy, the long-run equilibrium at E2 has
full employment output but a lower
price level than at E3. Mieno believed
that the SRAS adjustment would be
rapid, so he sought to avoid implementing a stabilization policy. Deflationary pressures still slowed the
economy in the remainder of the
1990s and the early 2000s, however,
contributing to slow economic
growth.
LRAS
Price level, P
622
SRAS0
E3
E0
E1
SRAS1
AD0
E2
AD1
Y1
Y*
Y0
Y
(say, retail sales) are available sooner. Second, even with data in hand, policymakers
often need a substantial amount of time to analyze the trends suggested by the economic
variables, which results in a recognition lag. That is, it takes time for policymakers to
detect the downturn. In addition, although policy interventions such as open market
purchases can be initiated by the Fed outside the legislative process, fiscal policies (such
as tax or spending changes) require legislative action. This is often a time-consuming
process, resulting in a legislative lag. Putting tax and expenditure policy into effect typically requires even more time, called an implementation lag. Even after a policy is
finally implemented, its effect on the economy isn’t immediate, creating an impact lag.
Because of these lags, policy interventions can’t begin to counterbalance every economic
fluctuation. Therefore economists generally advocate that policymakers focus on longrun objectives such as low inflation or steady economic growth.
Lags in the policymaking and implementation process haven’t convinced most new
Keynesian economists that stabilization policy lacks value. However, most economists
concur that policymakers shouldn’t attempt to fine-tune the economy, trying to smooth
every minor disturbance in aggregate demand. Instead, they argue, policymakers
should restrict the use of activist policy to fighting major downturns in the economy.
CHAPTER 26
Money and Output in the Short Run
623
Table 26.1 summarizes the money–output relationship and the desirability of stabilization policy according to the real business cycle, new classical, and new Keynesian
models.
Explaining Events of the 1980s, 1990s, and
Early 2000s
We are now ready to use new classical and new Keynesian analysis to analyze changes
in policy and to interpret the effects of these changes on output. Both the new classical
and new Keynesian views offer explanations for the short-run non-neutrality of money,
and both are consistent with rational decisions by households and businesses. But are
they consistent with actual economic events? We can find out by using these models to
interpret macroeconomic effects of policy shifts in the early 1980s, the early 1990s,
and the early 2000s. Although the different models may produce varying predictions
about the responses of output and interest rates to policy changes, they share an
emphasis on the importance of policy credibility for shaping those responses. That is,
announced changes in policy will influence households’ and businesses’ decisions only
to the extent that announcements are believed.
Effects of Policy Shifts in the Early 1980s
The early 1980s witnessed major shifts in both monetary and fiscal policies. Changes
in monetary policy had already begun in October 1979 when the Fed, under Chairman
Paul Volcker, announced that it would target monetary aggregates (instead of the federal funds rate) and that it would reduce the rate of money supply growth. Monetary
restraint continued more or less through 1981. In 1981, Congress and President Reagan agreed to the Economic Recovery Tax Act, which cut income tax rates significantly.
TA B L E 2 6 . 1
Summary of Monetary Policy and Output: Three Alternatives
Is Current Output Affected by an . . .
Alternative
Unexpected Change in
the Money Supply?
Expected Change in
the Money Supply?
Is Activist Policy
Desirable?
Real business
cycle model
No
No
No
Prices are perfectly flexible, so monetary policy
cannot affect real money balances or output
in the short run.
New classical
model
New Keynesian
model
Yes
No
No
Only unexpected changes in the money supply
affect output.
Monetary policy affects
output and the real
interest rate only by
“fooling” households
and firms.
Yes
Rarely
Yes
Both unexpected and expected changes in the
money supply affect output, although effects
of unexpected changes are greater.
Frequent changes in
monetary policy can
reduce the credibility of
the monetary authority.
624
PART 6
The Financial System and the Macroeconomy
FIGURE 26.5
Policy Mix in the Early 1980s
The economy’s adjustment to
aggregate demand shock in the
early 1980s is consistent with the
new Keynesian view.
1. From an initial equilibrium at
E 0 , a monetary contraction
shifts the AD curve from AD0
to AD1 , and output falls from
Y * to Y1. At E1 , the economy is in
a recession.
2. The fiscal stimulus from tax
cuts and increases in government
purchases shifts the AD curve
from AD1 to AD 2.
3. Over time, the net contraction
in output places downward pressure on inflation, shifting the
SRAS curve down from SRAS 0 to
SRAS 1 , restoring full employment
output at E2.
Price level, P
At the same time, government purchases of military equipment rose. Therefore monetary policy was contractionary, but fiscal policy was expansionary.
We can use the AD-AS diagram and the new Keynesian analysis to trace the effects
of these policy changes. In 1979, the economy was essentially at full employment, at
E0 , in Fig. 26.5. The monetary contraction shifted the aggregate demand curve to the
left from AD0 to AD1, shifting the economy’s equilibrium to E1. In response to the tax
cut and the military buildup, the AD curve shifted to the right from AD1 to AD2.
According to the new Keynesians, the effect on output of the policies of the early
1980s is ambiguous because the two shifts in aggregate demand were in opposite directions. Because the monetary contraction preceded the fiscal expansion by more than a
year, output should have fallen first—from Y* to Y1—which the actual drop in output
in two recessions during 1980–1982 confirmed. Inflation fell from double-digit levels
to about 4% by 1983, shifting the short-run aggregate supply curve from SRAS0 to
SRAS1. However, this occurred only after the economy endured the recession, a process
that is consistent with gradual price adjustment described by the new Keynesians.
When the price level adjustment was completed, the economy returned to a long-run
equilibrium at E2.
How would new classical economists interpret these events? The Fed stated on
many occasions that its shifts in monetary policy were intended to combat inflation.
According to new classical economists, an announced policy to reduce inflation could
lead to a combination of falling prices and lower expected inflation, which would
soften the leftward shift of the AD curve. This process of adjustment—the shift of the
short-run aggregate supply curve from SRAS0 to SRAS1—would be quicker than in the
new Keynesian analysis. Hence, at first glance, the new classical prediction is inconsistent with the experience of the economy during that period.
However, both the new Keynesian and new classical economists stress the importance of policy announcement credibility. Although Federal Reserve Chairmen Arthur
Burns and G. William Miller said that they wanted to reduce inflation in the 1970s,
actual Fed policy was inflationary. New classical and new Keynesian economists would
LRAS
1. Money
supply falls.
3. Expected price
level falls.
SRAS0
SRAS1
E0
E1
E2
2. Fiscal policy
stimulates AD.
AD0
AD2
AD1
Y1
Y*
Current output, Y
CHAPTER 26
Money and Output in the Short Run
625
predict that a lack of credibility about the Fed’s anti-inflation stance would fail to lower
prices or expectations of future inflation. Long-term interest rates increased from late
1979 through late 1981 (with the exception of the second quarter of 1980). Under the
expectations theory of the term structure of interest rates, the long-term rate is an average of expected future rates, so financial market participants probably didn’t expect
inflation to abate.
New classical economists believe that the Fed should try to reduce inflation in a major
one-shot policy shift, as long as that shift is announced and is credible. With the gradual
adjustment of prices in the new Keynesian view, gradual reduction in money growth could
reduce inflation with smaller costs from reduced output—again as long as the reductions
are announced and are credible.
Effects of Policy Shifts in the Early 1990s
At the beginning of the 1990s, the U.S. economy was at full employment equilibrium at
E0 in Fig. 26.6. Monetary and fiscal policy shifts in the early 1990s moved in opposite
directions from the policy shifts of the early 1980s. After substantial negotiation, President George H. W. Bush and the Congress compromised on a deficit-reduction bill in
October 1990 that increased taxes and reduced federal government spending, shifting
the AD curve to the left from AD0 to AD1. Fed Chairman Alan Greenspan, who had
often expressed concern about the pressure on interest rates from the federal budget
deficit, indicated to Congress that the Fed would ease monetary policy if a deficitreduction measure were adopted. The Fed followed through (but not fast enough in the
minds of some economists and policymakers), increasing the money supply growth rate.
This shifted the aggregate demand curve to the right from AD1 to AD2.
The economy suffered a recession, reducing output from Y* to Y1 in 1990 and
1991 and suggesting that the monetary stimulus may not have been sufficiently strong
at the time.✝ Over time, the weak economy put downward pressure on inflation,
FIGURE 26.6
LRAS
Price level, P
Policy Mix in the Early 1990s
The economy’s adjustment to
aggregate demand shock in the
early 1990s is consistent with the
new Keynesian view.
1. From an initial equilibrium at
E0, a fiscal contraction shifts the
AD curve from AD0 to AD1. Output
falls from Y* to Y1. The economy’s equilibrium shifts to E1.
2. A monetary stimulus shifts the
AD curve from AD1 to AD2.
3. Over time, the contraction in
output places downward pressure
on inflation, shifting the SRAS
curve from SRAS0 to SRAS1 and
restoring full employment output
at E2.
SRAS0
SRAS1
E0
1. Tax increase
reduces AD.
E2
E1
AD0
AD2
2. Money
supply rises.
Y1
Y*
AD1
Current output, Y
✝ In addition, during the early 1980s and early 1990s, there were adverse supply shocks from significant increases
in oil prices.
626
PART 6
The Financial System and the Macroeconomy
shifting the SRAS curve down from SRAS0 to SRAS1. The short-term real interest rate
fell, consistent with the new Keynesian predictions. The recession and gradual price
adjustment don’t support the new classical prediction that expected policy changes
should have no effect on unemployment. The move toward a new equilibrium at E2 in
1993 reflects full employment output, with lower inflation than at E0.
Although the credibility of U.S. monetary policy announcements may well have
been higher in the early 1990s than in the early 1980s, long-term interest rates did not
decline by as much as short-term rates during 1990–1992. This resistance suggests that
the public didn’t believe that inflation would be low in the long run (recall that the
long-term interest rate is the sum of the real interest rate and expected inflation). Both
the new Keynesian and new classical views suggest that a lack of credibility could
weaken the ability of monetary or fiscal policies to stimulate the economy.
The Early 2000s and Concluding Remarks
Evidence of effects on output of monetary and fiscal policies during the early 1980s and
early 1990s supports the new Keynesian view. In particular, even expected changes in
monetary policy can affect output and the real interest rate, with prices and inflation
adjusting only gradually. Also important is the implication of both the new Keynesian
and the new classical views that policy credibility is an important determinant of the
effect of policy shifts on the economy.
These observations are also useful in analyzing the 2001 recession and the recovery during 2002 and 2003. A sharp decline in the expected profitability of investment,
causing a fall in equity values and business investment, led to a recession. Throughout
2001, the Fed pursued an expansionary monetary policy, and the George W. Bush
administration proposed and won congressional approval for a large tax cut (and, following the terrorist attacks of September 11, 2001, government spending on defense
and homeland security rose). Expansionary monetary and fiscal policy mitigated the
adverse AD shift associated with the investment-led recession. Continuing rapid productivity growth—a favorable shift in the SRAS curve—put downward pressure on
inflation. The fall in the short-term real interest rate and the response of spending to
the policy changes is consistent with new Keynesian predictions. By late 2003, the
economy was moving to a new equilibrium, with full-employment output and lower
inflation. Even when nominal interest rates are low (as in the United States at the time),
monetary policy can still be efficient through changes in asset returns.
KEY TERMS AND CONCEPTS
Business cycle
Stabilization policies
Lags in the policymaking and
implementation process
SUMMARY
1. Economists generally agree that money is neutral in
the long run, but many disagree about whether
changes in the nominal money supply lead to changes
in output in the short run. Determining whether
changes in the money supply cause changes in output
requires looking at independent increases or decreases
in the money supply. Historical evidence suggests that
independent reductions in the rate of growth of the
nominal money supply have preceded declines in output. To interpret whether this relationship is causal,
economists describe the ways in which money affects
the economy.
CHAPTER 26
Money and Output in the Short Run
2. Money is neutral in the long run because prices are
flexible. In the real business cycle model, prices are
flexible even in the short run. The intersection of the
AD curve and the SRAS curve, which is vertical at the
full employment level of output, represents the economy’s equilibrium. Fluctuations in output are the
result of shifts in productivity. Changes in the nominal money supply have no effect on output, even in
the short run. Instead, movements of money and output together in the short run represent reverse causation: the effect of output on money demand, not the
effect of the money supply on output. However, historical evidence for the United States is not consistent
with the view that money is neutral in the short run.
3. New classical economists advance a different explanation of the relation of money and output. The misperception theory suggests a positive relationship
between output and unexpected changes in the price
level, based on the assumption that people have
rational expectations. Expected changes in the nominal money supply are neutral. Unexpected increases in
the nominal money supply increase real output. Evidence suggests that both expected and unexpected
changes in the nominal money supply affect real out-
627
put in the short run, implying that the new classical
view may be incomplete.
4. New Keynesian economists use sticky prices to
explain short-run non-neutrality of money. Prices are
slow to adjust, either because of long-term nominal
contracts or because of the combination of monopolistic competition and costs of adjusting prices. Both
expected and unexpected changes in the nominal
money supply affect output in the short run, but
unexpected changes have a greater effect.
5. Efforts to smooth short-run fluctuations in output are
known as stabilization policies. Real business cycle
proponents believe that stabilization policy is completely ineffective. Unexpected policy changes can
affect output in the new classical view, but they do so
only by fooling households and firms; policy credibility is enhanced by not fine-tuning short-run economic
fluctuations. Similarly, although new Keynesian economists argue that monetary policy can affect output
and real interest rates in the short run, they believe
that long-run policy goals are likely to be inconsistent
with numerous short-term interventions.
REVIEW QUESTIONS
QUIZ
1. Define the term “business cycle.” Why do economists
care about business cycles?
8. What is meant by stabilization policy? In theory, how can
stabilization policy be used during the business cycle?
2. Evaluate: Price flexibility necessarily implies that
money is neutral.
9. If new classical economists believe changes in the
money supply can have an effect on real output, why
are they opposed to stabilization policy?
3. Why might money be non-neutral when prices are set
by monopolistically competitive firms? Why might
money be non-neutral when long-term nominal contracts are important?
4. Why is it important to identify whether changes in
the money supply are independent of changes in
output?
5. Why is money neutral in the short run in the real business cycle model? If money is neutral, what causes business cycles in the real business cycle model?
6. How can money be neutral in the long run but not in
the short run in the new Keynesian model? What is
the primary difference between the real business cycle
model and the new Keynesian model?
7. What are the major differences between the new classical and new Keynesian models? What role does the
idea of rational expectations play in these two
approaches?
10. Milton Friedman and Anna Schwartz argue that bank
failures in the early 1930s and the Fed’s decision to
raise reserve requirements in 1937 led to declines in
the money supply. Why do bank failures and
increases in reserve requirements reduce the money
supply? Although Friedman and Schwartz have documented instances of the effect of independent movements in the money supply on real output, they are
skeptical of the usefulness of stabilization policy.
Why do you suppose they hold this position?
11. Define the following lags in the policymaking and
implementation process:
a. data lag;
b. recognition lag;
c. legislative lag;
d. implementation lag; and
e. impact lag.
628
PART 6
MOVING
The Financial System and the Macroeconomy
FROM
THEORY
TO
PRACTICE
THE WALL STREET JOURNAL
...
MAY 12, 2003
Monetary Policy Kicks In
For the first time in two
years, Americans may be
feeling a bit better about
their retirement accounts.
Investors are clamoring to
lend to debt-laden companies like Ford Motor Co.
and Duke Energy Corp. The
rising euro is boosting
expectations that the European Central Bank will soon
lower interest rates.
These are all signs that,
two years behind schedule,
a the Federal Reserve’s monetary medicine is finally
working as it should
When the Fed loosens
monetary policy, its most
visible action—lowering the
overnight rate banks charge
each other on loans—does
only part of the work. Its
impact is supposed to be
multiplied by rising stock
prices, falling long-term
b interest rates paid by corporations and a weakening
dollar. But between January
2001 and last October, as
overnight rates plunged
from 6.5% to 1.75%, the
multiplier effect failed to
engage. Stocks kept falling,
corporate-bond yields remained stubbornly high,
and the dollar actually
strengthened, all of which
kept the economy sluggish.
But since October, that
has been changing. When the
Fed first began easing, corporate-bond yields remained
stuck at 8% as shrinking
profits and an avalanche
of accounting scandals
increased investors’ fears of
default. . . .
Default fears have subsided dramatically. Since
October, the yield on bonds
of medium-quality industrial companies has plunged
from 8% to 6.4% and onceshunned borrowers have
been welcomed back to the
bond markets. . . .
Now, consider the stock
market. Far from the usual
rally that follows Fed easing, the Standard & Poor’s
500-stock Index, one broad
measure of the market,
plunged 40% in the 22
months after the Fed’s first
rate cut. But it’s up 20%
from its October low. . . .
Lower U.S. interest
rates are supposed to pull
down the dollar as investors
seek higher returns elsewhere. The problem for
most of 2001 and 2002 is
that “elsewhere” looked
like an even worse investment. . . .
But since last fall the
dollar has sunk 7%, half of
that in the last week as the
Fed’s announcement that it
in effect thought deflation a
greater risk than inflation
persuaded currency speculators the Fed may want the
dollar to fall to prop up
prices. To be sure, a weaker
dollar won’t reduce competition from China, which
ties its currency’s value to
the dollar. And there are
risks: Foreign economies
might wilt if their exporters’
sales dry up, or panicked
investors could dump U.S.
bonds, sending interest rates
higher.
But a happier outcome
could be taking shape.
Long-term interest rates
have actually dropped along
with the dollar, suggesting
someone is hungry for the
bonds foreigners are now
selling. While a weaker dollar may hurt exporters in
foreign economies, it will
also hold down inflation,
and encourage their central
banks to lower interest
rates. That would stimulate
domestic spending and take
the pressure off U.S. consumers to keep the world
afloat. “We’re in an environment of competitive
monetary reflation,” says
David Hale, an independent, Chicago-based economist. . . . There is no doubt
this has very strong stimula- c
tive effect. In a year we may
get a global boom.”
CHAPTER 26
ANALYZING
THE
Money and Output in the Short Run
NEWS
The recession of 2001 and its immediate aftermath promoted a vigorous
response by the Federal Reserve. Over
the course of 2001, the Fed reduced
the federal funds rate eleven times,
from a peak of 6.5 percent to 1.75
percent. In 2002 and 2003, continuing
Fed concern about the recovery and
the prospects for deflation led to a
continuing expansionary monetary policy. Some economists and financial
market participants worried that the
U.S. economy’s initially sluggish
response to the monetary stimulus
was a sign that monetary policy was no
longer effective in raising output in the
short run. This concern heightened as
nominal interest rates declined to very
low levels, seemingly limiting the central bank’s ability to advance the economic recovery. By late 2002 and
2003, however, conventional channels
through which monetary policy influences economic activity showed strong
signs of life.
629
...
the commencement of the recession,
Federal Reserve and government policymakers lacked that information in
real time, though they observed evidence of economic weakness.) At the
onset of the recession, the U.S. economy’s output lay at a level,Y, that was
less than its full employment level, Y*.
Under the new Keynesian view (which
is consistent with recent evidence linking money and output changes), a
switch to a more expansionary policy
shifts the AD curve to the right, from
AD0 to AD1 in part (a) of the figure,
raising output from Y0 to Y*. While the
policy change may put upward pressure on inflation, the gains in output
benefit many households and businesses. (Favorable productivity growth
minimized inflation risks, in the Fed’s
view.)
long-term low. Though buffeted by corporate accounting scandals post–September 11 concerns over terrorism,
U.S. equity values, too, eventually
responded to monetary stimulus.
Lower U.S. interest rates also reduced
the dollar’s value against many trading
partners. While there were lags in the
monetary transmission process, asset
prices responded predictably to the
Fed’s monetary stimulus.
Yes, but. . . In the long term,
greater output growth depends
on growth in productivity, or output
per worker. In analysis, this requires a
rightward shift of the LRAS curve, making possible higher output without
higher prices. Virtually no economist
would argue that the Fed can influence
the position of the LRAS curve.
c
For further thought . . .
b In the new Keynesian view, mon-
etary expansions increase U.S.
output through a combination of lower
interest rates, higher stock prices, and
The
Fed’s
switch
to
a
more
a lower foreign-exchange value of the
a
expansionary policy began as the dollar. Though the effect was not
economy entered a recession in 2001. immediate, the Fed’s strong signal that
(While the National Bureau of Eco- it would keep short-term interest rates
nomic Research dated March 2001 as low for some period of time reduced
The extent to which aggregate demand
shifts raise prices in the short run
depends on the slope of the SRAS
curve. How would you advise the Fed to
investigate the slope of the SRAS curve?
Source: Excerpted from Greg Ip, "Finally, Fed Gets Help From
Stocks, Bonds and Dollar," The Wall Street Journal, May 12, 2003.
Copyright © 2003, Dow Jones and Co. Reprinted by permission.
Price level, P
SRAS
E1
1. Fed pursues
expansion.
E0
AD1
AD0
2. Output rises.
Y0
(a)
Y*
Output, Y
630
PART 6
The Financial System and the Macroeconomy
12. Why does a monetary contraction put people out of
work? Use the AD-AS diagram for the new Keynesian
model to explain your answer.
13. If money is neutral, why is money growth correlated
with output growth in the real business cycle model?
ANALYTICAL PROBLEMS
QUIZ
14. Suppose that you observed a substantial decline in the
money growth rate six months before the start of every
recession. Would that be enough to convince you that
money affects output? Why or why not?
15. You are the Chairman of the Board of Governors of
the Federal Reserve System and have just learned that
the federal government is going to reduce expenditures sharply. This shock shifts the AD curve to the
left. How would you respond to keep the economy at
full employment equilibrium if
a. you use the new classical model?
b. you use the new Keynesian model?
In each case, show the AD-AS diagram associated
with your answer.
16. After years of spending more than their incomes, people decide to reduce their debt, thus increasing saving.
What effect does this action have on the AD curve? If
you are a new Keynesian economist in charge of monetary policy, what should you do?
17. Suppose that for the last several years output has
been at its full employment level and has not been
growing, and that the money supply has not been
growing. Suppose the Federal Reserve chairman
announces that he intends to increase the money
supply 5% to expand output. Explain how successful this policy will be from the point of view of the
new classical model and from the point of view of
the new Keynesian model. Illustrate your discussion
with an AD-AS diagram.
18. Suppose that for a long period of time, the Fed
maintained that it would not change monetary policy in response to recessions, but, in fact, it
expanded the money supply each time the economy
was in a recession. How would this pattern affect
the Fed’s credibility? Suggest implications for the
responses of interest rates on Treasury bills and 10year Treasury notes to the Fed’s interventions.
19. Suppose that the federal government seriously tried to
balance its budget by raising business taxes. Accord-
ing to the new classical view, what effect would this
action have on output and the price level? How
could monetary policy be used to offset this effect?
20. Fed officials, who can use expansionary or contractionary monetary policy to shift the AD curve, sometimes say that they “can’t do everything.” Using
AD-AS diagrams, illustrate how monetary policy can
be used to offset the effects of both AD and AS
shocks on output. How does the equilibrium price
level change in the two cases? Suppose that monetary
policy was used to stabilize the price level instead.
Draw AD-AS diagrams to show the effects of both
aggregate demand and aggregate supply shocks on
output. How does the equilibrium output level differ
in the two cases?
21. The increasing power of personal computers has
greatly increased the economy’s expected future productivity, increasing expected future output. What is
the likely effect of this development on aggregate
demand today? How might monetary policy be used
to offset this effect?
22. According to the new classical view, how should the
Fed use monetary policy to stabilize output in the
short run if the expected price level increases, shifting the SRAS curve up? What would the Fed need to
do in the long run to restore the initial price level?
How would your answer differ if you applied the
new Keynesian model?
23. (Difficult problem) Suppose that the economy is in
either a good state or a bad state and that monetary
policy is either contractionary or expansionary. Suppose further that the state of the economy and the
condition of monetary policy tell you all you need to
know to determine the unemployment rate and the
inflation rate. Finally, suppose that people care most
about the sum of the unemployment rate, u, and the
inflation rate, , which is called the misery index, or
m u . The respective factors and their values
are as follows:
Money and Output in the Short Run
CHAPTER 26
Economy
Monetary Policy
Factor
Contractionary
Expansionary
Good
Bad
10%
u
5%
5
3
m
10
13
u
4
8
10
4
m
14
12
If the economy is in a good state, a contractionary
monetary policy to prevent inflation is best. But if the
economy is in a bad state, an expansionary monetary
policy to help the economy recover is best. For example, with a contractionary monetary policy in a bad
state, the unemployment rate rises to 10% with only
3% inflation; with an expansionary monetary policy,
the unemployment rate is lower at 8%, with inflation
only slightly higher at 4%.
a. If the Fed knows exactly when the state of the
economy changes and it changes policy to minimize the misery index, what is its monetary policy and the misery index when the economy is
good? When the economy is bad?
b. Now suppose that there are some lags in the
process. Suppose further that the Fed doesn’t
know the current state of the economy, but
knows only what it was six months ago (that is,
631
there may be both recognition and data lags).
Then suppose that if the economy was in a good
state six months ago, the probability is 90%
that it is still in a good state today and 10% that
it is now in a bad state; if the economy was in a
bad state six months ago, the probability is
75% that it is now in a good state and 25% that
it is now in a bad state. If the Fed wants to minimize the misery index on average, what should
its policy be if the economy was in a good state
six months ago? If it was in a bad state six
months ago?
c. Suppose that in addition to the data and recognition lags, there is also an effectiveness lag of six
months. What should policy be today if the economy was in a good state six months ago? If it was
in a bad state six months ago?
d. What do your answers to (a)–(c) suggest about
the ability of policymakers to use stabilization policies?
24. The text states that “most economists concur that
policymakers shouldn’t attempt to fine-tune the economy, trying to smooth every disturbance in aggregate
demand. Instead, they argue, policymakers should
restrict the use of activist policy to fighting major
downturns in the economy.” Evaluate Fed policy in
the late 1990s in the light of these observations.
DATA QUESTIONS
25. Find monthly or quarterly data on the (civilian) unemployment rate from 1946 to the present in a source
such as Business Statistics or Employment and Earnings (for more recent data, see the Survey of Current
Business or the Economic Report of the President).
Looking just at the unemployment rate data, try to
guess when all the recessions since 1946 began and
when they ended. Compare your answers to the information in Fig. 26.1 on page 612.
26. Find some measure of the inflation rate (consumer price
index, producer price index, GDP deflator) in a major
data source, such as the Economic Report of the President, for each year since 1946. Cover the inflation rates
shown for 1960 to the present with a piece of paper.
Now, on the basis of the historical inflation rates for
1946 to 1959, estimate the inflation rate for 1960.
Then, looking only at the data for 1946 to 1964, estimate the inflation rate for 1965. Repeat for 1970,
1975, 1980, 1985, 1990, 1995, 2000, and 2003. Now
compare your estimates to the actual inflation rates.
How close were you? Were your estimates of inflation
based on rational expectations? What other information besides past inflation rates would you find useful
when forecasting inflation?
27. The growth of the money supply varies over the business cycle. Consider the money supply data found in
the most recent issue of Economic Indicators, a
monthly publication of the Council of Economic
Advisers at http://www.gpoaccess.gov/indicators/
browse.html. Based on the table entitled “Money,
Credit, and Security Markets,” which monetary
aggregate—M1, M2, or M3—appears to be most
responsive to changes in the business cycle? Explain
your answer in terms of the efficiency of Federal
Reserve monetary tools. (In other words, over which
aggregate does the Fed appear to have more control?
Why does this make sense in terms of the construction of the aggregates?)
632
PART 6
The Financial System and the Macroeconomy
28. How closely related is the unemployment rate to the
business cycle? Obtain unemployment rate statistics
for 1948 to the present from the Bureau of Labor Statistics’ Labor Force Statistics site at http://data.bls.
gov/cgi-bin/surveymost?ln. Using the graph function
provided, explain whether there is such a relationship
between (i) the unemployment rate and recessions,
and (ii) the unemployment rate and expansions.