Question

In the Friedman-Lucas money surprise model, suppose that the objective of the Central Bank is to INCREASE the real interest rate. In order to achieve this objective, suppose that the Central Bank has two different policy options:

1. Announce in advance that the nominal money supply will decrease;
2. Surprise the public with a decrease in the nominal money supply.

In terms of achieving the objective of the Central Bank, which policy proves to be more effective? Why? What are the outcomes of each policy action in terms of key macroeconomic variables, i.e. the price level, output, employment, real interest rate, real wage? What are the welfare consequences of such policy actions? Explain using appropriate diagrams and discuss.

Answer 1

The Freidman-Lucas money supply model states that only unanticipated and surprise changes in money can lead to changes in output. A shift in money supply which is planned often gives the economy preparation time to adjust to what is going to come in the future. They maintain the neutrality of money in the long-run because any alterations would have had time to adjust. Thus, in terms of achieving the objective of the Central Bank, a surpise announcement is more effective. Let us examine how each of the alternatives will play out.

If it is announced in advance that the nominal money supply will decrease, people would be aware that interest rates and going to rise. In such a case, they might increase their borrowing in the current period at lower interest rates. This is how it will look like in the money market -

So even before the money supply could decrease, money demand would increase to MD' changing the interest rates frm I to I'.

Also, due to increased money demand, consumption and investment in the economy would go up shifting the AD curve to the right.

As the AD curve moves to right to AD', equilibrium output in the economy expands to Y', and equilibrium price level rises to P'.

More output in the economy would lead to increase in labor demand (D'). This could create shortage of labor, thus increasing wage rate (W') and employment level (L') in the economy.

As opposed to this, if the central bank surprises the public with a decrease in nominal money supply, the money market would look like the below -

Money supply curve would shift left to MS' and the interest rate would rise to I'.

In the output market, decreased money supply would lead to less consumption and investment since the interest rates are now higher. This would lead the aggregate demand curve to shift to the left.

With AD curve shifting left to AD', output will contract to Y' and price level in the economy would fall to P'.

In the labor market, less output means less demand for labor. This would shift labor demand curve to the left (D'), decreasing the wage rate (W') and employment (L').

In terms of welfare consequences, it is better for the public to be prepared for what is going to come in the future, than be surprised by it. But this approach, however, might not achieve the intended results for the Central Bank.