Paul Schneiderman, Ph.D., Professor of Finance & Economics, Southern New Hampshire University ©2008 South-Western

Monetarist Views  Velocity changes in a predictable way but does not change very much from one period to the next  Aggregate demand depends on the money supply and velocity  The SRAS curve is upward sloping  The economy is self regulating (prices and wages are flexible)

Monetarism in a AD–AS Framework Money Supply Increases

Monetarism in a AD–AS Framework Money Supply Decreases

Monetarism in a AD–AS Framework Velocity Increases

Monetarism in a AD–AS Framework Velocity Decreases

Monetarist View of the Economy Monetarists believe:  the economy is self-regulating.  changes in velocity and the money supply can change aggregate demand.  changes in velocity and the money supply will change the price level and Real GDP in the short run but only the price level in the long run.

Self-test Questions  What do monetarists predict will happen in the short run and in the long run as a result of each of the following (in each case, assume the economy is currently in long-run equilibrium)? a. Velocity rises. b. Velocity falls. c. The money supply rises. d. The money supply falls.  Can a change in velocity offset a change in the money supply (on aggregate demand)? Explain your answer.

Inflation Increase in the Price Level I One-Shot Inflation - A one-time increase in the price level. An increase in the price level that does not continue.

One-Shot Inflation: Demand-Side Induced I  The aggregate demand curve shifts rightward from AD1 to AD2.  As a result, the price level increases from P1 to P2.  The economy moves from point 1 to point 2.

One-Shot Inflation: Demand-Side Induced II  Because the Real GDP the economy produces (Q2) is greater than Natural Real GDP, the unemployment rate that exists is less than the natural unemployment rate.  Wage rates rise, and the short-run aggregate supply curve shifts leftward from SRAS1 to SRAS2.  Long-run equilibrium is at point 3.

One-Shot Inflation: Supply-Side Induced I  The short-run aggregate supply curve shifts leftward from SRAS1 to SRAS2.  As a result, the price level increases from P1 to P2; the economy moves from point 1 to point 2.

One-Shot Inflation: Supply-Side Induced II  Because the Real GDP the economy produces (Q2) is less than Natural Real GDP, the unemployment rate that exists is greater than the natural unemployment rate.  Some economists argue that when this happens, wage rates will fall and the short-run aggregate supply curve will shift rightward from SRAS2 (back to SRAS1).  Long-run equilibrium is at point 1.

Inflation Increase in the Price Level II Continued Inflation - A continued increase in the price level.

Continuous Inflation I Begins with Shift in AD  The aggregate demand curve shifts rightward from AD 1 to AD 2.  The economy initially moves from point 1to point 2 and finally to point 3.  Continued increases in the price level are brought about through continued increases in aggregate demand.

Continuous Inflation II  The short-run aggregate supply curve shifts leftward from SRAS1 to SRAS2.  The economy initially moves from point 1 to point 2.  The economy will return to point 1 unless there is an increase in aggregate demand.  We see here that continued increases in the price level are brought about through continued increases in aggregate demand.

2 Inflation Questions 1. Can continued declines in SRAS cause continued inflation? Not likely as it is not supported by recent history, and, wages are not likely to increase as demand for labor decreases. 2. What causes continued increases in aggregate demand? Continued ↑ in M → Continued ↑ in AD → Continued inflation

Self-test Questions  The prices of houses, cars, and television sets have increased. Has there been inflation?  Is continued inflation likely to be supply- side induced? Explain your answer.  What type of inflation is Milton Friedman referring to when he says that “inflation is always and everywhere a monetary phenomenon”?

Economic Variables Affected by a Change in the Money Supply  The supply of loans  Real GDP  The price level, and  The expected inflation rate

The Interest Rate and the Loanable Funds Market

Liquidity Effect The change in the interest rate due to a change in the supply of loanable funds.

Income Effect The change in the interest rate due to a change in Real GDP.

Price Level Effect The change in the interest rate due to a change in the price level.

Expectations Effect The change in the interest rate due to a change in the expected inflation rate

How the Fed Affects the Interest Rates Liquidity Effect → Income Effect → Price Level Effect → Expectations Effect → ↓ ↓ ↓

Nominal Interest Rate  The interest rate actually charged (or paid) in the market; the market interest rate.  Nominal interest rate = Real interest rate + Expected inflation rate. i%i%i%i%

Real Interest Rate  The nominal interest rate minus the expected inflation rate. When the expected inflation rate is zero, the real interest rate equals the nominal interest rate.  Real interest rate = Nominal interest rate – Expected inflation rate i%i%i%i%

Self-Test Questions  If the expected inflation rate is 4 percent and the nominal interest rate is 7 percent, what is the real interest rate?  Is it possible for the nominal interest rate to immediately rise following an increase in the money supply? Explain your answer.  The Fed only affects the interest rate via the liquidity effect. Do you agree or disagree? Explain your answer.

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