An enduring question in macroeconomics: does monetary policy have any important effects on the real (i.e, real GDP, consumption, etc) economy?
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1 ONETARY OLICY IN THE INFINITE-ERIOD ECONOY: SHORT-RUN EFFECTS NOVEBER 6, 20 oneary olicy Analysis: Shor-Run Effecs IS ONETARY OLICY NEUTRAL? An enduring quesion in macroeconomics: does moneary policy have any imporan effecs on he real (i.e, real GD, consumpion, ec) economy? Definiion: oney (and hence moneary policy) is neural if changes in he money supply (i.e., changes in moneary policy) have no effec on he real economy oneary policy is non-neural if i does have effecs on he real economy New Keynesian view: money is non-neural (because prices are rigid/sicky, ofen for long periods of ime) RBC view: money is neural (because prices are no rigid/sicky in any imporan way) IU framework allows us o consider how/why moneary policy is or is no neural November 6, 20 2
2 oneary olicy Analysis: Shor-Run Effecs ONEY DEAND Consumpion-money opimaliy condiion he foundaion of money demand funcion Example: suppose u c, = lnc + ln Thus, u c, = and u 2 c, = (no chain rule his ime ) c / Consumpion-money opimaliy condiion (for his uiliy funcion ) is c i = + i Isolae he / erm = c i REAL ONEY DEAND FUNCTION: depends posiively on c and negaively on i (i is he opporuniy cos of money) Use his money demand funcion o analyze The moneary neuraliy debae The long-run (aka seady-sae) connecion beween moneary policy and inflaion November 6, 20 3 oneary olicy Analysis: Shor-Run Effecs ONEY DEAND CONSUTION-ONEY OTIALITY CONDITION u2( c, / ) i = u ( c, / ) + i NOTE: consumpion-money opimaliy condiion and money demand funcion are he same hing, jus viewed from differen poins of view RS (beween consumpion and real money holdings) price raio (beween consumpion and money) Using uiliy funcion u c, = lnc + ln, generae money demand funcion REAL ONEY DEAND FUNCTION: depends posiively on c and negaively on i (i is he opporuniy cos of money) = c i Use money demand funcion o illusrae effecs of money (moneary policy) shocks Ges a core of neuraliy debae Le s be even more precise abou he iming of evens November 6,
3 oneary olicy Analysis: Shor-Run Effecs ONETARY NEUTRALITY DEBATE recise iming of evens wihin period Fed ses acual afer consumers makes heir choices of c and planned (and oher choices, oo ) If acual differs from planned, money shock has occurred November 6, 20 5 oneary olicy Analysis: Shor-Run Effecs ONETARY NEUTRALITY DEBATE recise iming of evens wihin period Fed ses acual afer consumers makes heir choices of c and planned (and oher choices, oo ) If acual differs from planned, money shock has occurred Quesion: which adjuss ( or c ) o ensure consumpion-money opimaliy condiion holds? (simplify by assuming i doesn adjus) = c i November 6,
4 oneary olicy Analysis: Shor-Run Effecs ONETARY NEUTRALITY DEBATE Quesion: which adjuss ( or c ) o ensure consumpion-money opimaliy condiion holds? (simplify by assuming i doesn adjus) = c i Keynesian/New Keynesian view canno adjus because prices are sicky (rices will adjus laer (i.e, in period + or laer), jus no in period ) A posiive (negaive) money shock leads o a rise (fall) in c oney (and hence moneary policy) is no neural November 6, 20 7 oneary olicy Analysis: Shor-Run Effecs ONETARY NEUTRALITY DEBATE Quesion: which adjuss ( or c ) o ensure consumpion-money opimaliy condiion holds? (simplify by assuming i doesn adjus) = c i Keynesian/New Keynesian view canno adjus because prices are sicky (rices will adjus laer (i.e, in period + or laer), jus no in period ) A posiive (negaive) money shock leads o a rise (fall) in c oney (and hence moneary policy) is no neural RBC view can adjus because prices are no sicky No reason for c o adjus (hey do reflec opimal choices, afer all...) A posiive (negaive) money shock leads o no change (no change) in c oney (and hence moneary policy) is neural Empirical evidence for how sicky are prices is very mixed November 6,
5 oneary olicy Analysis: Shor-Run Effecs ONETARY NEUTRALITY DEBATE: EXALE Assume i = 0.25 is fixed Consumers planned choices are c = 2 and = 80 This plan was made wih = 0 in mind Fed ses acual = 270 (a posiive money shock because acual greaer han planned ) Keynesian/New Keynesian view = 0 won change (sicky prices) c will rise (o c = 3) o make consumpion-money opimaliy condiion hold oneary policy is non-neural = c i RBC view Consumers plan of c = 2 is wha he economy really wans can fully and quickly adjus o accommodae his = 5 oneary policy is neural; only effec of moneary policy is on inflaion November 6, 20 9 oneary olicy Analysis: Shor-Run Effecs ONETARY NEUTRALITY DEBATE AD Expansionary moneary policy shifs AD eriod- goods marke GD November 6,
6 oneary olicy Analysis: Shor-Run Effecs ONETARY NEUTRALITY DEBATE AS (if prices adjus insanly ) AD The crucial issue: how quickly do nominal prices adjus? AS (if prices very sicky in adjusing) Expansionary moneary policy shifs AD GD eriod- goods marke November 6, 20 The Three acro arkes THE THREE ACRO (AGGREGATE) ARKETS Goods arkes Demand derived from C-L framework (Shape of AS funcion?...depends how quickly nominal prices adjus) S D Labor arkes Supply derived from C-L framework Demand derived from firm heory in C-S framework wage S goods D Capial/Savings/Funds/Asse arkes (aka Financial arkes) Supply derived from C-S framework Demand derived from firm heory in C-S framework real ineres rae November 6, 20 2 S D labor savings/in vesmen 6
7 ONETARY OLICY IN THE INFINITE-ERIOD ECONOY: LONG-RUN EFFECTS NOVEBER 6, 20 oneary olicy Analysis: Long-Run Effecs ONEY AND INFLATION IN THE LONG-RUN Quesion: wha deermines inflaion in he long run (i.e., in seady-sae)? Use boh period-(-) and period- money demand funcions o analyze oney demand funcion in - = c i oney demand funcion in = c i / c = / c i i Divide period money demand by period - money demand November 6,
8 oneary olicy Analysis: Long-Run Effecs ONEY AND INFLATION IN THE LONG-RUN Quesion: wha deermines inflaion in he long run (i.e., in seady-sae)? Use boh period-(-) and period- money demand funcions o analyze oney demand funcion in - = c i oney demand funcion in = c i Divide period money demand by period - money demand Recall definiion of inflaion / c = / c i i π = μ c = π c i i And now define he money growh rae in an analogous way: μ = Impose seady sae i.e., c - = c = c, i - = i = i, π = π, and μ = μ μ c i = π c i i November 6, 20 5 oneary olicy Analysis: Long-Run Effecs ONEY AND INFLATION IN THE LONG-RUN Quesion: wha deermines inflaion in he long run (i.e., in seady-sae)? Use boh period-(-) and period- money demand funcions o analyze oney demand funcion in - = c i oney demand funcion in = c i Divide period money demand by period - money demand Recall definiion of inflaion / c = / c i i π = μ c = π c i i And now define he money growh rae in an analogous way: μ = Impose seady sae i.e., c - = c = c, i - = i = i, π = π, and μ = μ μ c i = π c i i μ = π IN LONG RUN, RATE OF ONEY GROWTH = RATE OF INFLATION November 6,
9 oneary olicy Analysis: oney and Inflaion ONETARIS μ = π IN LONG RUN, RATE OF ONEY GROWTH = RATE OF INFLATION In seady sae, inflaion deermined solely by how quickly cenral bank (Fed) expands (or shrinks) he nominal money supply This relaionship he basis for he monearis school of hough ilon Friedman s famous dicum: Inflaion is always and everywhere a moneary phenomenon olicy ranslaion: A cenral bank should no worry abou/ry o conrol anyhing oher han how quickly he money supply in he economy is growing. Keeping money growh under conrol will keep inflaion under conrol. November 6, 20 7 oneary olicy Analysis: oney and Inflaion ONETARIS μ = π IN LONG RUN, RATE OF ONEY GROWTH = RATE OF INFLATION In seady sae, inflaion deermined solely by how quickly cenral bank (Fed) expands (or shrinks) he nominal money supply This relaionship he basis for he monearis school of hough ilon Friedman s famous dicum: Inflaion is always and everywhere a moneary phenomenon olicy ranslaion: A cenral bank should no worry abou/ry o conrol anyhing oher han how quickly he money supply in he economy is growing. Keeping money growh under conrol will keep inflaion under conrol. Rose o prominence in mid- and lae 970 s (during macro crises) Larges policy influence in U.K., shor-lived policy influence in U.S. Largely died ou as basis for serious policy advice by mid-980 s Neverheless sill viewed as fundamenal law of macroeconomics A concern oday: Fed s easy moneary policy (read: Fed has increased money supply very rapidly) will lead o a burs of inflaion November 6,
10 oneary olicy: Wrapup ONETARY OLICY In shor-run, do changes in moneary policy have effecs on consumpion and real GD? Keynesian/New Keynesian view: yes because prices are sicky RBC view: no because prices are no sicky In long-run, changes in money growh rae Have effecs on only inflaion Have no effecs on consumpion and real GD Compeing principles/heories influence policy-makers decisions Basic models are guideposs for policy debaes Acual policy-making quie messy Requires lo of judgmen Requires hope/belief ha basic models are a leas somewha useful guides o hinking Nex: ineracions beween moneary policy and fiscal policy November 6,
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