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16. Monetary Dynamics
37. Be able to describe the effects of an acceleration or deceleration of base money growth through the very short run, the short run, and the long run. Illustrate with money supply and demand, short run and long run Phillips curves.
38. Be able to use a short run Phillips curve to show the effects of increased inflation in the short run.
39. Be able to use a long run Phillips curve to show the effects of increased inflation in the long run.
Dynamic Short Run Aggregate Supply
A dynamic short run aggregate supply function could be found by taking the differences of the short run function between t and t-1.
. . . .
ytsSR = yt* + εt + 1/d1 (Pt - Pte - δt)
The growth rate of short run aggregate supply is equal to the growth rate of potential income plus 1/d1 times the inflation rate minus the expected inflation rate less the price level shock.
The Short Run Phillips Curve
Many economists use the short run Phillips curve to represent the dynamic relationship between the inflation rate and short run aggregate supply. It actually was just an empirical generalization--data suggests that high inflation goes with low unemployment and vice versa. Still, the relationship can be derived from the short run aggregate supply function. The basic idea is the when income grows more slowly than potential income, then unemployment rate is above the natural unemployment rate. If the growth rate of real income is equal to the growth rate of short run aggregate supply in the short run:
. .
ut = unt -d2(ytsr - lnypt)
Okuns law is another empirical regularity--in recent U.S. history, d2 has been about 1/3.
Substitution with the dynamic aggregate supply results in:
. .
ut = unt -d2/d1(Pt - Pte - δt)
The higher the inflation rate, the lower the unemployment rate, other things being equal. But notice that a higher expected inflation rate or a positive shock to the price level will raise the unemployment rate.
The graph of the short run Phillips curve is simple.
Long Run Dynamic Equilibrium
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In the long run, the expected inflation rate becomes equal to the actual inflation rate. Ignoring shocks, real income grows with potential income which is equal to base capacity. But shocks do exist, and at any given time:
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. . . . .
Pt = b2(1-b3)/c2 (c0-c1Δtt+c3gt+c4xt-c5nt)
. . . .
+ (Bt+mt)- (c2b1+b2(1-b3))/c2 yt*
+ 1/(c2d1+c2b1+b2(1-b3)) [d1b2(1-b3) γt + c2d1(αt-βt) - d1(c2b1+b2(1-b3))εt
+ (c2b1+b2(1-b3))δt]
. .
yt = yt* + 1/(c2d1+c2b1+b2(1-b3)) [d1c2εt + b2(1-b3)γt + c2(αt-βt) - c2δt]
. . . .
Δrbt = 1/c2 (c0-c1Δtt+c3gt+c4xt-c5nt- yt*
- 1/(c2d1+c2b1+b2(1-b3)) [d1c2εt + b2(1-b3)γt + c2(αt-βt) - c2δt])
The Long Run Phillips Curve
In the long run, the inflation rate is equal to the expected inflation rate. The long run Phillips curve is then:
ut = unt + (d2/d1)δt
If there are no price level shocks, then the unemployment rate is equal to the natural unemployment rate and independent of the inflation rate. The long run Phillips curve is a vertical line.
Acceleration of the Growth of Base Money
An increase in the growth rate of base money leads to an increase in the growth rate of the money supply.
The monetary acceleration will influence many variables over time, but it will leave some unchanged. Other things being equal, an acceleration of money growth will leave the growth rate of the money multiplier, the growth rate of potential income, the natural unemployment rate, and the natural interest rate unchanged through the very short run, the short run, and the long run.
Monetary Acceleration in the Very Short Run
In the very short run, an acceleration of money growth
causes the supply of money to grow more rapidly than the demand for money. Excess money is spent on assets, asset prices rise, so the nominal market interest rate (Rb) decreases This can be illustrated with a supply and demand for money diagram. (Put numbers on your graph if you have them.)
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Assuming that expected inflation is unchanged or increases, the decrease in the nominal market interest rate implies a decrease in the real bond interest rate (r decreases). The natural interest rate is unchanged, so the very short run involves macroeconomic disequilibrium because the real bond interest rate is below the natural interest rate.
(Aside--The natural interest rate is the real interest rate at which saving and investment are equal. Investment and saving are at the levels consistent with income equal to potential income. It can be calculated by setting the IS relationship equal to potential income and solving for the bond interest rate.
rn = 1/c2 (c0-c1tt+c3lngt+c4lnxt-c5lnnt- lnyt*
- 1/(c2d1+c2b1+b2(1-b3)) [d1c2εt + b2(1-b3)γt + c2(αt-βt) - c2δt])
This is, of course, the level of the bond interest rate in long run equilibrium.)
The growth rate of real income, the unemployment rate, and the inflation rate have yet to change in the very short run, but that will not last long, since the excessively low interest rates will begin to stimulate spending.
Monetary Acceleration: The Short Run
In the short run, an acceleration of monetary growth causes more rapid growth of aggregate demand. This causes more rapid growth of real income as firm react to rapid sales growth by expanding production, which also implies a decrease in the unemployment rate. The firms also increase their prices more rapidly, which implies some increase in the inflation rate. The increase in the inflation rate and the decrease in the unemployment rate is illustrated using the short run Phillips curve.
The more rapid increase in income and prices raises the growth rate of money demand. This tends to cause the nominal bond interest rate and the real interest rate to rise again and approach the natural interest rate.
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The economy remains in disequilibrium because income is greater than potential income and income is growing more quickly than potential income. Further, the unemployment rate is less than the natural unemployment rate and the inflation rate is greater than the expected inflation rate. The situation is sometimes described as a boom, but more usually called the late stage of a recovery.
Monetary Acceleration: Long Run
In the long run, the macro economy returns to equilibrium. The only persistent effects of the increase in the growth rate of base money is an increase in the growth rate of the money supply, an increase in the inflation rate, an increase in the expected inflation rate, and an increase in the nominal interest rate.
The boom will not persist, because when the unemployment rate is less than the natural unemployment rate, shortages of labor cause more rapid increases in wages. Shortages of other resources cause more rapid increases in the prices of other resources. (bottlenecks cause price increases) As firms increase prices to cover rapidly increasing costs, real income returns to potential income. The growth rate of real income is again equal to the growth rate of potential income.
As rising costs force firms to raise price faster and raise output more slowly, the short run Phillips curve shifts to the right (illustrate). The longrun Phillips curve shows that the unemployment rate is again equal to the natural unemployment rate, in spite of the higher inflation.
Once people recognize the higher inflation rate, the expected inflation rate adjusts to the new inflation rate and the nominal market interest rate must increase to compensate creditors. The new nominal market interest rate is equal to the natural interest rate plus the new inflation rate.
In the long run, the economy has returned to macroeconomic equilibrium. The acceleration of the growth rate of base money causes a higher growth rate of the money supply, a higher inflation rate, and higher expected inflation rate, and a higher nominal bond interest rate. But the real bond interest rate is equal to the natural interest rate, growth rate of real income equals the growth rate of potential income, the unemployment rate equals the natural unemployment rate.
Deceleration of Base Money Growth
A deceleration of base money growth causes a decrease in the growth rate of the money supply. The monetary deceleration will influence many variables over time, but it will leave some unchanged. Other things being equal, a deceleration of money growth will leave the growth rate of potential income, the natural unemployment rate, and the natural interest rate unchanged through the very short run, the short run, and the long run.
Deceleration of Money Growth: Very Short Run
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In the very short run, a deceleration of money growth causes the supply of money to grow less than the demand for money. Assets are sold to obtain money, asset prices fall, and the nominal bond interest rate increases. This can be illustrated with a supply and demand for money diagram.
Assuming the expected rate of inflation is unchanged or has decreased, the real bond interest rate increases. The very short run involves macroeconomic disequilibrium because the real bond interest rate is above the natural interest rate. In the very short run, the growth rate of real income, the inflation rate, and the unemployment rate have yet to change. But this cannot last for long, because the higher real bond interest rate will start to depress spending growth.
Deceleration of Money Growth: Short Run
In the short run, a deceleration of money growth causes less rapid growth in aggregate demand. The most important effect is a decrease in the growth rate of real income or even shrinking real income as firms react to slower sales by restricting production. This results in an increase in the unemployment rate. Firms simultaneously moderate their price increases (cut prices from the higher levels they had planned). The result is a decrease in the inflation rate. The short run Phillips curve shows that the decrease in the inflation rate is associated with an increase in the unemployment rate.
In the short run, the slower growth rate of real income (and slower inflation rate) causes the demand for money to grow more slowly. The nominal bond interest rate and the real bond interest rate can decrease back towards the natural interest rate.
The short run involves macroeconomic disequilibrium because real income is less than potential income and the unemployment rate is greater than the natural unemployment rate. This is usually described as a bust or recession (or maybe "growth" recession).
Deceleration of Money Growth: Long Run
In the long run, the macro economy returns to equilibrium. The deceleration of the growth rate of base money leaves a lower growth rate of the money supply, a lower inflation rate, a lower expected inflation rate, and a decrease in the nominal interest rate.
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The recession eventually ends, because when real income is less than potential income and the unemployment rate is greater than the natural unemployment rate, surpluses of labor allow firms to slow wage increases to less than increases in productivity. They can also hire new workers at lower wages. And sometimes wages are actually cut (called give backs by unions). Unit costs grow more slowly. Firms expand production, so real income rises to potential income. The growth rate of real income is again equal to the growth rate of potential income.
As slower increases in costs and competition causes firms to expand output and limit price increases, the short run Phillips curve shifts to the left. The long run Phillips curve shows that the lower inflation rate is consistent with the unemployment rate returning to the natural unemployment rate.
Once people recognize the lower inflation rate, the nominal market interest rate decreases because less is necessary to compensate creditors for the lower expected inflation rate. The new nominal bond interest rate is equal to the natural interest rate plus the new inflation rate.
In the long run, the decrease in the growth rate of base money causes a lower growth rate of the money supply, and lower inflation rate, a lower expected inflation rate, and a lower nominal market interest rate. But the economy is in macroeconomic equilibrium because the real market interest rate is equal to the natural interest rate, the growth rate of real income is equal to the growth rate of potential income, and the unemployment rate is equal to the natural unemployment rate.