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Equation of Exchange
- M^s x V= P x Y
- M^s- money supply
- V- velocity of money
- P- price level
- Y- GDP
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Assumptions of Classical Model (QT)
- 1. V is constant (spending habits of households are stable)
- 2. People demand money for transaction purpose.
- 3. Y is at Y*P (self adjusting economy)
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The Monetarist Transmission Mechanism
- M^s to Transactions to AD to Prices - everything
- Restrictive monetary policy to limit inflationary effects
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Keynesian Liquidity Preference Theory of Money
- Demand for money-
- Following the monetarist keynesians saw a transaction demand for money
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Keynesian Speculative Demand
- Money is viewed as an asset (or alternative form of wealth)
- Other assets we will call bonds
- Viewing money as an asset- if we had money we incur an opportunity cost which is the rate of return on bonds.
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4 Determinants of Demand for Money
- 1. Changes in the price level- if prices level increases than MD will increase. VV
- 2. Changes in GDP- if GDP increases then MD will increase. VV
- 3. Changes in technology- the atm reduces MD beause they reduce our demand for cash.
- 4. Changes in institutions- when regulation Q was eliminated in 1980- interest rates were then paid on demand deposites
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Fed increases Ms
- People have surplus money
- They use that money to purchase bonds
- As the purchase bonds- the price of bonds rise
- As the price of bonds increase, rules of return on bonds fall.
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New Classical
- Economy is self adjusting.
- Says law- supply creates its own demand.
- Policy minimum government intervention.
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New Keynesian
- Economy not self adjusting.
- AD can be deficient
- Government should intervene to stimulate AD
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Milton Friedman
- Reformulate the Q theory of money.
- He incorporated the speculative demand for money into the model.
- Argued speculative demand is not as important as transactions demand.
- Central bank should follow a policy rule.
- Look at equation.
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Natural Rate or Fooling Model
- Assume
- 1. Workers mispercieve movements in the price level.
- 2. The economy is at capacity (y=y*p; unemployment = natural rate.)
- 3. The policy makers do not recognize the natural rate of unemployment.
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Rational Expectations Model- Robert Lucas
- Both workers and employers can misprecieve movements in the price levels.
- Both workers and employers would work to develope rational expectations where they accurately predict movements in the price level.
- Workers and employers are rational actors so they will continually seek information to accurately predict prices.
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Real Business Cycle
- Finn K. and Edward Prescott
- The business represents fluctuation in the potential GDP.
- To this point we have argued the business cycle is denotations in actual from potential GDP.
- Policy- nothing can be done on the demand side to stabalize the economy. Monetary and fiscal policy are ineffective.
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New Keynesian Economics
- Do sticky prices gum up the economy.
- DEveloped hypothesis exploring why prices in the economy are rigid.
- Menu costs, explicit and implicit contracts.
- See SRAS as being stable. So if there is a shock that reduces AD. The economy can become stuck below full employment. GRAPH
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