6.

New Macroeconomics

• New Macroeconomics
• Rational Expectations Theory.
• Monetarism.
Phillips curve & Expectations theory
• What is the Phillips curve?
• How has the natural rate of unemployment changed in Zambia over
time?
• What determines the expected rate of inflation?
• How can we tell how expectations of inflation are formed--whether
they are static, adaptive, or rational?
….
• Whenever unemployment is equal to its natural rate, inflation is equal
to expected inflation
• the position of the Phillips curve can be determined if we know the natural
rate of unemployment and the expected inflation rate
….shifts in the Phillips curve
• The Phillips curve shifts if either Expected inflation or the natural rate
of unemployment changes or if a supply shock occurs
• a higher natural rate moves the Phillips curve to the right
• higher expected inflation moves the Phillips curve up
• adverse supply shocks move the Phillips curve up
Rational Expectation theory
• There are three basic scenarios for how inflation expectations are
formed
• static expectations
• prevail when people ignore the fact that inflation can change
• adaptive expectations
• prevail when people assume the future will be like the recent past
• rational expectations
• prevail when people use all the information they have as best they can
…continue Rational expectancy theory
• The idea that past outcome influences future outcomes.
• The theory believes that because people make decisions based on
available information at hand coupled with their past experiences,
most of the time their decisions will be correct.
• People make decisions based on the best available information,
including their own expectations about future events.
• Implying that individuals are rational and use all available info to
make informed decisions.
…..Rational expectations
• The theory suggests that people’s current expectations of the
economy are, themselves, able to influence what the future state of
the economy will become.
• This concept contrasts with the idea that government policy
influences financial and economic decisions.
Rational expectations and market clearing
• If firms have rational expectations, on average, prices and wages will
be set at levels that ensure equilibrium in the goods and labor
markets.
• When expectations are rational, disequilibrium exists only temporarily
as a result of random, unpredictable shocks.
• On average, all markets clear and there is full employment. There is
no need for government stabilization.
Monetarism
• The main message of monetarism is that money matters.
• Monetarism is a macroeconomic theory which states that
governments can foster economic stability by targeting the growth
rate of the money supply.
• Inflation (an increase in P) is always a purely monetary phenomenon.
• If the money supply does not change, the price level will not change.
• Monetarists advocate a policy of steady and slow money growth, at a
rate equal to the average growth of real output (Y).
• it is a set of views based on the belief that the total amount of money
in an economy is the primary determinant of economic growth.
Monetarism- Impact of monetary policy
• A brief historical background:
• The Keynesian view dominated during the 1950s and 1960s.
• Keynesians argued that money supply did not matter much.
• Monetarists challenged the Keynesian view during the 1960s and 1970s.
• Monetarists argued that changes in the money supply caused both
inflation and economic instability.
• While minor disagreements remain, the modern view emerged from this
debate.
• Modern Keynesians and monetarists agree that monetary policy exerts an
important impact on the economy. How…
Demand and supply of money
Money
interest Money
• Equilibrium = Md=Ms rate Supply
Excess supply
at i2
i2
At ie, people are
willing to hold the
ie money supply set
by the Fed.

i3 Excess demand
at i3
Money
Demand
Quantity
of money
How does monetary policy affect the
economy?
• Expansionary monetary policy
Transmission of Money S1 S2 Money

Monetary Policy interest Balances

rate

• When the BOZ shifts to a more i1

expansionary monetary policy, it usually
buys additional bonds, expanding the
i2
money supply.
D1
• This increase in the money supply (shift
Quantity
from S1 to S2 in the market for money) Qs Qb of money
provides banks with additional reserves.
Real S1 Loanable
• The BOZ’s bond purchases and the bank’s interest Funds
rate
use of new reserves to extend new loans
increases the supply of loanable funds S2
(shifting S1 to S2 in the loanable funds r1
market) and puts downward pressure
on real interest rates (a reduction to r2).
r2
D Qty of
loanable
Q1 Q2 funds
Transmission of Real
interest
S1 Loanable
Funds
Monetary Policy rate

S2
r1

• As the real interest rate falls, AD increases r2

(to AD2). D Qty of
• When the monetary expansion is Q1 Q2
loanable
funds
unanticipated, the expansion in AD leads
to a short-run increase in output (from Y1
to Y2) and an increase in the price level Price
Level AS1
(from P1 to P2) – inflation.
• The impact of a shift in monetary policy
is transmitted through interest rates,
exchange rates, and asset prices. P2

P1
AD2
AD1 Goods &
Services
Y1 Y2 (real GDP)
….transmission of monetary policy
…..expansion policy when economy is below
capacity
…expansion policy when economy is at full
employment
….at full employment (LR)
How does monetary policy affect the
economy?
• Contractionary monetary policy
• Lets suppose BOZ sells bonds
• depress bond prices and
• drain reserves from the banking system,
• which places upward pressure on real interest rates.
• As a result, an unanticipated shift to a more restrictive monetary policy reduces
aggregate demand and thereby decreases both output and employment.
• Demonstrate with the aid of graphs (contractionary money policy)
• The transmission of monetary policy
• Contraction monetary policy when the economy is below capacity
• Contraction monetary policy when economy is at full employment
• Contraction monetary policy when economy is at full employment (LR)
Economic stability and shifts in Monetary
Policy
• If a change in monetary policy is timed poorly, it can be a source of
instability.
• It can cause either recession or inflation.
• Proper timing of monetary policy:
• If expansionary effects occur during a recession and restrictive
effects during an inflationary boom, the impact would be
stabilizing.
• However, if expansionary effects occur when an economy is
already at or beyond full employment and restrictive effects occur
when an economy is in a recession, the impact would be
destabilizing.
Long run effects of a rapid expansion in
Money Supply
The quantity theory of money

• The AD-AS model illustrates that nominal GDP is the product of

the price (P) and output (Y) of each final-product good purchased during
the period.
• GDP can also be visualized as the money stock (M) multiplied by the
number of times the money stock is used to buy those final goods &
services (V).
• If V and Y are constant, then an increase in M will lead to a proportional
increase in P.
Long run impact of monetary policy – modern
view
• Long-run implications of expansionary policy:
• When expansionary monetary policy leads to rising prices, decision
makers eventually anticipate the higher inflation rate and build it
into their choices.
• As this happens, money interest rates, wages, and incomes will
reflect the expectation of inflation, and so real interest rates,
wages, and real output will return to long-run normal levels.
• Thus, in the long run, money supply growth will lead primarily to
higher prices (inflation) just as the quantity theory of money
implies.
Long run effects of a rapid expansion in
money supply
• Here we illustrate the long-term impact of an increase in the annual
growth rate of the money supply from 3% to 8%.
• Initially, prices are stable (P100) when the money supply is expanding
by 3% annually.
• The acceleration in the growth rate of the money supply increases
aggregate demand (shift to AD2).
 …long run effects of a rapid expansion in MS

• Example, we illustrate the long-term impact

of an increase in the annual growth rate of
the money supply from 3% to 8%.
• Initially, prices are stable (P100) when the
money supply is expanding by 3% annually.
• The acceleration in the growth rate of the
money supply increases aggregate demand
(shift to AD2).
…long run effects of a
rapid expansion in MS

• At first, real output may expand

beyond the economy’s potential
YF .
• However, low unemployment and
strong demand create upward
pressure on wages and other
resource prices, shifting SRAS1
to SRAS2.
• Output returns to its long-run
potential YF, and price level
increases to P105 (E2).
…long run effects of a
rapid expansion in MS
• If the more rapid monetary
growth continues, then AD
and SRAS will continue to
shift upward, leading to still
higher prices (E3 and points
beyond).
• The net result of this
process is sustained
inflation.
long run effects of rapid
expansion in MS on
loanable funds market

•With stable prices, supply and

demand in the loanable funds
market are in balance at a real
& nominal interest rate of 4%.
•If rapid monetary expansion
leads to a long-term 5%
inflation rate, borrowers and
lenders will build the higher
inflation rate into their
decision making.
•As a result, the nominal
interest rate i will rise to 9%.
Money and inflation
• The impact of monetary policy differs between the
short-run and the long-run.
• In the short run, shifts in monetary policy will affect real output
and employment. A shift toward monetary expansion will
temporarily increase output, while a shift toward monetary
restriction will reduce output.
• But, in the long-run, monetary expansion will only lead
to inflation. The long-run impact of monetary policy is consistent
with the quantity theory of money.
Economic stability & proper monetary policy
• Monetary policy that provides approximate price stability
(persistently low rates of inflation) is the key to sound stabilization
policy
• Modern living standards are the result of gains from trade,
specialization, division of labor, and mass production processes.
• Price stability will facilitate the smooth operation of the pricing system
and the realization of these gains.
• In contrast, high and variable rates of inflation create uncertainty,
distort relative prices, and reduce the efficiency of markets.