The classical dichotomy divides variables into real variables (variables that measure quantities or relative prices) and nominal variables (variables that are measured in monetary terms).

According to classical macroeconomic theory, changes in the money supply affect nominal variables but not real variables, that is, monetary neutrality.

Most economists believe that classical theory describes the world in the long run but not in the short run.

When looking at year-to-year economic changes, the assumption of monetary neutrality no longer applies. In the short run, real variables and nominal variables are highly correlated, and changes in the money supply can temporarily cause real GDP to deviate from its long-term trend.

Models of short-run economic fluctuations focus on the behavior of two variables: the first is the economy's output of goods and services, measured by real GDP; the second is measured by the CPI or GDP deflator. overall price level.

Aggregate Demand and Aggregate Supply Model: A model used by most economists to explain short-term fluctuations in economic activity around its long-term trend.

Aggregate demand curve: A curve showing the quantity of goods and services that households, businesses, governments, and foreign customers want to buy at each price level.

Aggregate supply curve: A curve that shows the quantity of goods and services that firms choose to produce and sell at each price level.

The aggregate demand and aggregate supply models are completely different from the market demand and market supply models in microeconomics. Microeconomic substitution from one market to another is not possible for the economy as a whole.

1. Price level and consumption: wealth effect. Lower price levels increase the real value of money and make consumers wealthier, which in turn encourages them to spend more. Increased consumer spending means greater demand for goods and services. Conversely, rising price levels reduce the real value of money and make consumers poorer, which in turn reduces consumer spending and the quantity of goods and services demanded.

2. Price level and investment: interest rate effect. The price level is a determinant of the quantity of money demanded. A lower price level lowers interest rates, encouraging more spending on investment goods, thereby increasing the demand for goods and services. Conversely, rising price levels raise interest rates, dampen investment spending, and reduce the quantity of goods and services demanded.

3. Price level and net exports: exchange rate effect. When the U.S. price level falls, causing U.S. interest rates to fall, the real value of the dollar in the foreign exchange market falls. This depreciation stimulates U.S. net exports, thereby increasing demand for goods and services. Conversely, when the U.S. price level rises and causes U.S. interest rates to rise, the real value of the dollar rises, and this appreciation reduces U.S. net exports and the quantity of goods and services demanded.

Importantly, the aggregate demand curve is drawn assuming "other things being equal", and in particular, all three explanations of the downward-sloping aggregate demand curve assume that the money supply is fixed. A change in the quantity of money shifts the aggregate demand curve.

1. Shifts caused by changes in consumption: When the price level is given, events that increase consumer spending (tax cuts, stock market surges) shift the aggregate demand curve to the right; when the price level is given, events that decrease consumer spending ( Tax increases, stock market downturns) shift the aggregate demand curve to the left.

2. Movement caused by changes in investment: When the price level is given, events that increase corporate investment (optimism about the future, a decrease in interest rates due to an increase in money supply) shift the aggregate demand curve to the right; Events that reduce business investment (pessimism about the future, rising interest rates due to a reduction in the money supply) shift the aggregate demand curve to the left.

3. Shifts caused by changes in government purchases: increases in government purchases of goods and services (increased spending on national defense or highway construction) shift the aggregate demand curve to the right; decreases in government purchases of goods and services (cuts in spending on national defense or highway construction) spending on highway construction) shifts the aggregate demand curve to the left.

4. Movement caused by changes in net exports: When the price level is given, events that increase net export spending (foreign economic prosperity, speculation that causes exchange rate declines) shift the aggregate demand curve to the right; when the price level is given, net export spending is reduced Events (foreign recession, speculation causing exchange rate increases) shift the aggregate demand curve to the left.

In the long run, an economy's production of goods and services (its real GDP) depends on its supply of labor, capital, and natural resources, and on the technology available to convert these factors of production into goods and services.

The price level does not affect these long-run determinants of real GDP, so the long-run aggregate supply curve is vertical.

The aggregate supply curve is vertical only in the long run.

Natural level of output: The level of production of goods and services that an economy achieves in the long run when unemployment is at its normal rate.

Any change in the economy that changes the natural level of output shifts the long-run aggregate supply curve.

1. Movement caused by labor changes. Any change in the number of workers and the natural unemployment rate will shift the long-term aggregate supply curve.

2. Movement caused by changes in capital. An increase in the capital stock in the economy increases productivity, thereby increasing the supply of goods and services, with the result that the long-run aggregate supply curve will shift to the right. Otherwise, move to the left.

3. Changes in natural resources cause movement.

4. Movement caused by changes in technical knowledge.

Although many factors determine the economy in the long run, and in theory these factors can cause such a move, the two most important factors in the real world are technology and monetary policy.

Long-term trends are the result of the superposition of short-term fluctuations. Short-term fluctuations in output and price levels should be viewed as departures from sustained long-term trends in output growth and inflation.

The long-run aggregate supply curve is vertical because in the long run the aggregate price level does not affect the economy's ability to produce goods and services. In contrast, in the short run the price level does affect the economy's output. The short-run aggregate supply curve slopes upward to the right.

When the actual price level in the economy deviates from people's expected price levels, supply deviates from its long-term or natural level.

1. Sticky wage theory. According to the sticky wage theory, the short-run aggregate supply curve slopes upward because nominal wages are determined based on expected prices, and when the actual price level turns out to be different from the expected level, nominal wages do not respond immediately.

2. Sticky price theory. Sticky price theory emphasizes that the prices of some goods and services are also slow to adjust to changes in economic conditions.

3. Illusion theory. According to the illusion theory, changes in the general price level temporarily mislead suppliers about what is happening in the individual markets in which they sell their products. Because of these short-run illusions, suppliers respond to changes in the price level, and this response causes the aggregate supply curve to slope upward to the right.

Supply of output = natural output level α (actual price level – expected price level) where α is the number that determines how much output responds to unexpected changes in the price level.

Whether the short-run aggregate supply curve slopes upward to the right is due to sticky wages, sticky prices, or an illusion, these conditions are not permanent.

When considering what causes the short-run aggregate supply curve to shift, we must consider all the variables that shift the long-run aggregate supply curve plus a new variable—the expected price level, which affects sticky wages, sticky prices, and the illusion of relative prices .

Shifts in the long-run aggregate supply curve are typically caused by changes in labor, capital, natural resources, and technological knowledge, and these same variables also shift the short-run aggregate supply curve.

When people change their expectations about the price level, the short-run aggregate supply curve will also shift.

General conclusion: An increase in the expected price level reduces the supply of goods and services and shifts the short-term aggregate supply curve to the left; a decrease in the expected price level increases the supply of goods and services and shifts the short-term aggregate supply curve to the right.

1. Determine whether an event shifts the aggregate demand curve or the aggregate supply curve (or both curves).

2. Determine the direction of the curve movement.

3. Use graphs of aggregate demand and aggregate supply to illustrate how this shift affects output and the price level in the short run.

4. Use aggregate demand and aggregate supply diagrams to analyze how the economy changes from its new short-term equilibrium to its long-term equilibrium.

1. In the short run, movements in aggregate demand cause fluctuations in the output of goods and services in the economy.

2. In the long run, movements in aggregate demand affect the overall price level, but do not affect output.

3. Policymakers who influence aggregate demand can potentially mitigate the severity of economic fluctuations.

1. Movements in aggregate supply will cause a combination of stagflation-recession (reduced output) and inflation (increased prices).

2. Policymakers who can influence aggregate demand can potentially mitigate the adverse effects on output, but only at the expense of exacerbating the inflation problem.

Liquidity preference theory: Keynes's theory, which believes that the adjustment of interest rates balances money supply and money demand. This theory of interest rate determination will help explain why the aggregate demand curve slopes downward to the right, and how monetary and fiscal policy can shift this curve.

This theory is essentially just an application of supply and demand. According to Keynes, adjustments in interest rates balance money supply and money demand.

Money supply: The first part of the liquidity preference theory is the money supply. The money supply in the U.S. economy is controlled by the Federal Reserve, which changes the money supply mainly by changing the amount of reserves in the banking system by buying and selling government bonds in open market operations. Because the money supply is fixed by the Fed's policy, it does not depend on other economic variables, in particular it does not depend on interest rates.

Demand for Money: The second part of the liquidity preference theory is the demand for money. Liquidity refers to the ease with which the asset can be converted into a medium of exchange in the economy. While many factors determine the quantity of money demanded, one factor highlighted by liquidity preference theory is interest rates. An increase in interest rates increases the cost of holding money, so the demand for money decreases; a decrease in interest rates reduces the cost of holding money, and increases the demand for money.

Equilibrium in the money market: According to the liquidity preference theory, the adjustment of interest rates balances the supply and demand of money.

Loanable funds theory and liquidity preference theory are used for different purposes. When considering the long-term determinants of interest rates, it is best to remember the loanable funds theory, which emphasizes the importance of the propensity to save and investment opportunities in the economy. When considering the short-term determinants of interest rates, it is best to remember the liquidity preference theory, which emphasizes the importance of monetary policy.

The price level is a determinant of the quantity of money demanded. A higher price level increases the quantity of money demanded given the interest rate.

The analysis of the interest rate effect can be summarized into three steps: (1) higher price levels increase money demand; (2) higher money demand causes higher interest rates; (3) higher interest rates reduce The quantity demanded of goods and services. The same logic works in the opposite direction.

As illustrated by a downward-sloping aggregate demand curve, there is a negative relationship between the price level and the quantity of goods and services demanded.

Whenever the quantity demanded of goods and services changes at a given price level, the aggregate demand curve shifts.

When the Fed increases the money supply, it lowers interest rates, increases the quantity of goods and services demanded at a given price level, and shifts the aggregate demand curve to the right. When the Fed tightens the money supply, it raises interest rates, reducing the quantity of goods and services demanded at a given price level, shifting the aggregate demand curve to the left.

In recent years, the Federal Reserve has used policy by setting a target for the federal funds rate - the interest rate banks charge each other on short-term loans.

Liquidity preference theory illustrates an important principle: monetary policy can be described in terms of both money supply and interest rates.

Conclusion: Monetary policy changes aimed at expanding aggregate demand can be described as both an increase in the money supply and a reduction in interest rates; monetary policy changes aimed at tightening aggregate demand can be described as both a decrease in the money supply and a decrease in interest rates. for interest rate increases.

Liquidity trap: According to the liquidity preference theory, expansionary monetary policy works by lowering interest rates and stimulating investment spending. However, if interest rates have fallen to close to zero, then monetary policy may no longer be effective. Nominal interest rates will not fall below zero. In this case, expansionary monetary policy increases the money supply and makes the public's portfolio more liquid, but since interest rates cannot fall any further, the additional liquidity will no longer have any effect. Aggregate demand, production and employment would be "stuck" at low levels.

When policymakers change the money supply or the level of taxes, it indirectly shifts the aggregate demand curve by affecting the spending decisions of firms or households. In contrast, when the government changes its purchases of goods and services, it directly shifts the aggregate demand curve.

There are two macroeconomic effects that make the magnitude of changes in aggregate demand different from changes in government purchases: the first is the multiplier effect; the second is the crowding out effect.

Multiplier effect: The additional change in aggregate demand caused when expansionary fiscal policy increases income and thus consumer spending.

The multiplier effect occurs because an increase in total income stimulates additional spending by consumers.

Positive feedback from investment demand is sometimes called an investment acceleration number.

Marginal Propensity to Consumption (MPC): The proportion of a household's extra income that is spent on consumption rather than on savings.

Multiplier = 1/(1-MPC) This multiplier formula illustrates an important conclusion: the size of the multiplier depends on the marginal propensity to consume. The larger the MPC, the larger the multiplier.

The logic of the multiplier effect is not limited to changes in government purchases; it applies to any event that changes spending in any component of GDP—consumption, investment, government purchases, or net exports.

In macroeconomics, the multiplier is an important concept because it illustrates how much the economy can multiply the effects of changes in spending.

Crowding out effect: The reduction in aggregate demand caused when expansionary fiscal policy causes interest rates to rise, thereby reducing investment spending.

The crowding-out effect partially offsets the impact of government purchases on aggregate demand.

When the government increases purchases by a certain amount, the increase in total demand for goods and services can be greater or less than that amount, depending on the size of the multiplier effect and the crowding-out effect.

Another important tool of fiscal policy is the level of taxes. The magnitude of changes in aggregate demand caused by tax changes is also affected by the multiplier effect and the crowding-out effect.

In addition to the multiplier and crowding-out effects, there is another important factor that determines the magnitude of the change in aggregate demand caused by a tax change: households' perception of whether the tax change is permanent or temporary.

If monetary policy responds appropriately, joint changes in monetary and fiscal policy can keep aggregate demand for goods and services unaffected.

The main argument is that these policies have a considerable time lag in their economic impact. Critics of stabilization policy claim that the Fed often reacts too late to changing economic conditions, causing economic fluctuations rather than containing them. These critics favor negative monetary policies such as low and stable money supply growth.

There is also a time lag when fiscal policy takes effect, but the time lag in fiscal policy is mainly due to the political process.

Automatic Stabilizer: Fiscal policy changes that stimulate aggregate demand when the economy enters a recession without policymakers taking any intentional action.

All economists agree that time lags in policy implementation make policy less effective as a short-term stabilization tool.

The most important automatic stabilizer is the tax system. Government spending also acts as an automatic stabilizer.

In 1958, Phillips published "The Relationship between Unemployment and the Rate of Change of Money Wages in Britain, 1861-1957" in the "Economics" magazine. In this article, Phillips explained the relationship between the unemployment rate and the inflation rate. negative correlation. In 1960, Samuelson and Solow published "An Analysis of Anti-Inflation Policies" in the "American Economic Review", using U.S. data to show the negative relationship between inflation and unemployment. Their reasoning is that this correlation occurs because low unemployment is associated with high aggregate demand, and high aggregate demand puts upward pressure on wages and prices throughout the economy. Samuelson and Solow called the negative relationship between unemployment and inflation the Phillips curve.

Policymakers can choose any point on this curve by changing monetary and fiscal policies to affect aggregate demand.

The Phillips Curve illustrates that the combination of inflation and unemployment that occurs in the short term is due to a shift in the aggregate demand curve that causes the economy to move along the short-term aggregate supply curve.

Changes in aggregate demand cause inflation and unemployment to move in opposite directions in the short run, which is exactly the relationship illustrated by the Phillips curve.

Because monetary policy and fiscal policy can shift the aggregate demand curve, they can move the economy along the Phillips curve. The Phillips Curve provides policymakers with a menu of combinations of inflation and unemployment.

Friedman and Phelps concluded (based on the principles of classical macroeconomics) that there is no reason to think that inflation and unemployment are related in the long run.

The growth of the money supply determines the inflation rate. Regardless of the inflation rate, the unemployment rate tends to the natural rate of unemployment. Therefore, the long-run Phillips curve is vertical.

The vertical long-run Phillips curve shows that in the long run, unemployment does not depend on money growth and inflation.

The vertical long-run Phillips curve and the vertical long-run aggregate supply curve are two sides of the same coin. Both mean that monetary policy only affects nominal variables (price level and inflation rate) but does not affect real variables (output and unemployment). ). Regardless of the monetary policy adopted, in the long run output and unemployment are at their natural levels.

The natural unemployment rate is not necessarily the socially desirable unemployment rate, nor is it static.

Faster money growth does not weaken the market power of unions or reduce unemployment levels; it simply causes higher inflation.

While monetary policy cannot affect the natural rate of unemployment, other policies can. Policy changes that lower the natural rate of unemployment will shift the long-run Phillips curve to the left and the long-run aggregate supply curve to the right, so that the economy can enjoy lower unemployment at any given rate of money growth and inflation. and higher yields.

Friedman and Phelps introduced a new variable into the analysis of the trade-off between inflation and unemployment: expected inflation. Expected inflation measures how much people expect the general level of prices to change. Because the expected price level affects nominal wages, expected inflation is a factor in determining the position of the short-run aggregate supply curve.

In the short run, changes in the quantity of money cause unexpected fluctuations in output, prices, unemployment, and inflation.

The Fed's ability to cause unanticipated inflation by increasing the money supply exists only in the short term.

Friedman and Phelps' analysis can be summarized as follows: Unemployment rate = natural unemployment rate - α (actual inflation - expected inflation) The variable α is a measure of how responsive unemployment is to unexpected inflation.

This equation means that there is no stable short-run Phillips curve. Each short-run Phillips curve reflects a specific expected inflation rate.

Friedman and Phelps concluded that policymakers face only a short-term trade-off between inflation and unemployment. In the long run, a faster expansion of aggregate demand will cause higher inflation without any reduction in unemployment.

Natural rate hypothesis: The view that regardless of the rate of inflation, unemployment will eventually return to its normal or natural rate.

Sacrifice ratio: The percentage of annual output lost during a one percentage point reduction in inflation. The sacrifice rate is generally estimated to be 5, that is, for every percentage point reduction in the inflation rate, 5% of output must be sacrificed each year in this transformation.

If a country wants to reduce inflation, it must endure a period of high unemployment and low output. The size of this cost depends on the slope of the Phillips curve and how quickly inflation expectations adjust to the new monetary policy.

Rational expectations: The theory that when people predict the future, they can make full use of all the information they have, including information about government policy.

Proponents of rational expectations, based on the Friedman-Phelps analysis, point out that when economic policy changes, people adjust their inflation expectations accordingly, something that studies of inflation and unemployment that attempt to estimate sacrifice rates fail to take into account The direct impact of policy institutions on expectations. Therefore, according to rational expectations theorists, estimates of sacrifice rates are an unreliable guide to policy.

According to Sargent, the sacrifice rate may be much smaller than previously estimated. Indeed, in the most extreme case, the sacrifice rate can be zero: if the government makes a credible commitment to a low-inflation policy, people are rational enough to immediately lower their inflation expectations. The short-run Phillips curve will shift downward, and the economy will soon reach low inflation without paying the price of temporarily high unemployment and low output.

The annual data plot of unemployment rate and inflation rate (measured by GDP deflator) from 1979 to 1987 shows that Volcker's anti-inflation did come at the expense of high unemployment.