PowerPoint Presentation by Charlie Cook Copyright © 2004 South-Western. All rights reserved. Chapter 24 Different Views on How Monetary Policy Affects the Economy

Copyright © 2004 South-Western. All rights reserved.24–2 Fundamental Issues 1.What factors determine aggregate demand in the traditional Keynesian model? 2.What factors determine the shape and position of the Keynesian aggregate supply schedule? 3.According to traditional Keynesian theory, what are the price and output effects of expansionary monetary policies?

Copyright © 2004 South-Western. All rights reserved.24–3 Fundamental Issues (cont’d) 4.In what respects do modern economic theories reach similar and conflicting conclusions about the relationship between monetary policy and economic activity?

Copyright © 2004 South-Western. All rights reserved.24–4 Keynesian Theory of Aggregate Demand The monetary transmission mechanism:  At all price-level and real income combinations along the Keynesian aggregate demand schedule, financial markets are in equilibrium, and income is equal to aggregate desired expenditures. Real balance effect:  An increase in the nominal rate of interest that results from an increase in the price level, holding total depository institution reserves unchanged.

Copyright © 2004 South-Western. All rights reserved.24–5 Deriving the Keynesian Aggregate Demand Schedule Figure 24–1

Copyright © 2004 South-Western. All rights reserved.24–6 The Effect of Open Market Purchases on Aggregate Demand Figure 24–2

Copyright © 2004 South-Western. All rights reserved.24–7 A Sticky-Wage Theory Of Aggregate Supply Explicit contracts:  Contractual arrangements in which the terms of relationships between workers and firms, especially about wages, are in writing and legally binding upon both parties. Implicit contracts:  Unwritten agreements between workers and firms, concerning terms of employment such as wages, that may or may not be legally binding.

Copyright © 2004 South-Western. All rights reserved.24–8 The Value of the Marginal Product of Labor Value of the marginal product of labor:  The marginal product of labor times the price of output.

Copyright © 2004 South-Western. All rights reserved.24–9 Keynesian Aggregate Supply Schedule with Wage Inflexibility Figure 24–3

Copyright © 2004 South-Western. All rights reserved.24–10 Keynesian Aggregate Supply with Imperfect Information Figure 24–4

Copyright © 2004 South-Western. All rights reserved.24–11 Keynesian Theories of Aggregate Supply Nominal wages are inflexible:  A rise in nominal wages following union demands for higher wages or increases in a legal minimum wage will shift the aggregate supply schedule upward and to the left. Workers have imperfect information:  A higher expectation of the price level shifts the aggregate supply schedule upward and leftward.

Copyright © 2004 South-Western. All rights reserved.24–12 Equilibrium in the Keynesian Market for Real Output Figure 25–5

Copyright © 2004 South-Western. All rights reserved.24–13 The Price-Level and Real Output Effects of Expansionary Monetary Policy Figure 24–6

Copyright © 2004 South-Western. All rights reserved.24–14 Price and Output Effects of Expansionary Monetary Policies A Federal Reserve policy of sustained open market purchases causes an increase in aggregate demand which results in:  A rise in the equilibrium price level.  An increase in equilibrium real output. Fed watching:  Developing forecasts of Federal Reserve monetary policy actions based on careful examination of the process by which the Fed appears to make its policy decisions.

Copyright © 2004 South-Western. All rights reserved.24–15 Anticipated versus Unanticipated Monetary Policy in the New Classical Model Figure 24–7

Copyright © 2004 South-Western. All rights reserved.24–16 The New Classical Policy Ineffectiveness Proposition Policy ineffectiveness proposition:  The new classical view that systematic (predictable) monetary policy actions will not have short-run effects on real quantities. Observational equivalence:  The modern Keynesian theory with sticky wages makes some of the same fundamental policy predictions as the new classical model that is based on pure competition with completely flexible wages.

Copyright © 2004 South-Western. All rights reserved.24–17 New Keynesian Theory versus Real Business Cycles New Keynesian economists:  Emphasize the potential importance of differences, or heterogeneities, among households and firms.  Contend that monetary policy actions can have significant effects on real output. Real-business-cycle theorists:  Espouse models based on the assumption of homogeneous, or identical, households and firms.  Conclude that little if any stabilizing role exists for monetary policy.

Copyright © 2004 South-Western. All rights reserved.24–18 Key Term Small menu costs:  The costs firms incur when they make price changes, such as the costs of changing prices in menus or catalogues and the costs of renegotiating agreements with customers.

Copyright © 2004 South-Western. All rights reserved.24–19 Keynesian Market Failures Market failure:  The failure of a private market to reach an equilibrium that reflects all the costs and benefits entailed in producing a good or providing a factor service. Aggregate externalities:  Situations in which aggregate equilibrium in all, or at least many, markets fails to account for spillovers across markets, so that equilibrium aggregate real output, employment, and the price level all differ from their long-run, natural levels.

Copyright © 2004 South-Western. All rights reserved.24–20 Keynesian Market Coordination Failures Coordination failures:  Spillover effects between workers and firms, arising from movements in economic variables, that hinder efforts by individual households and firms to plan and implement their consumption, production, and pricing decisions.

Copyright © 2004 South-Western. All rights reserved.24–21 Real-Business-Cycle Theory Real-business-cycle theory:  An approach to the theory of overall economic activity in which variations in technology are the key factors accounting for cyclical fluctuations in real output.  Inside money: Bank deposit money.  Outside money: Money in the form of currency and bank reserves.

Copyright © 2004 South-Western. All rights reserved.24–22 Technology Shocks and Real Output Variations. Figure 28–8

Copyright © 2004 South-Western. All rights reserved.24–23 Labor Market Flexibility and Unemployment Rates in Selected Nations Figure 24–9 SOURCE: Rafael Di Tella and Robert MacCulloch, “The Consequences of Labor Market Flexibility: Panel Evidence Based on Survey Data,” Harvard Business School, November 1998.

Copyright © 2004 South-Western. All rights reserved.24–24 Unemployment Rates in Ireland and the Netherlands Figure 24–10 SOURCES: Cedric Tille and Kei-Mu Yi, “Curbing Unemployment in Europe: Are There Lessons from Ireland and the Netherlands?” Federal Reserve Bank of New York Current Issues in Economics and Finance 7 (5, May 2001); Organization for Economic Cooperation and Development.