Question

Consider a monetary intertemporal model we introduced in Part II of Money section. Consider a shock to the economy we studied in Chapter 13 as the likely driver of the business cycle, that is a persistent shock to the producitivity parameter of the economy.

a. Suppose that the central bank fully controls money supply and keeps it constant. What would be the impact of a persistent productivity shock on the price level in the economy? Would you expect the price level to be pro-, counter- or acyclical? Explain your answers, illustrate them with graphs if necessary.

b. Now, suppose that the central bank controls only the monetary base, but the money multiplier is procyclical. As a result, money supply aggregates like M1 and M2 expand whenever output expands. How would the price level behave over cycle in this situation? Would your answer from part a) change? Explain and illustrate your answers with graphs if necessary

Answer 1

a.) A consistent productivity shock means increased productivity due to a sudden increase in the level of technology in the economy that persists for a long time. That means that even if there are the same factors of production (labour and capital) available in the eocnomy, the productivity is more and because of that the output has to be more. This kind of a productivity shock will increase the aggregate supply in the economy, leading to a fall in prices at constant aggregate demand. This is because people in the economy will have the same purchasing power in the short run, but goods will be excess, as a result of which sellers will be willing to sell them at lower prices. This will lead to a fall in the price level in the economy with a growth in the GDP, which means that the price level movement will be acyclic. This will happne when the central bank decided to keep the money supply constant, as increasing the money supply at this stage would lead to increase in the level of prices again. However, this will only be short lived, as the increase in technical know how will increase supply and also increase purchasing power by increasing employment in the long run, which will increase aggregate demand and bring back prices to the same level.

b.) If the money multiplier is porcyclic, and the money in circulation increases with rise in the GDP, then in this case, the price level will also rise. This is because people will have more money to pay for the more goods and services that are being produced in the economy. If the rate of money growth is more than the rate of growth of output, then prices will rise. This means that in this case, the price level is procyclic. If the money multiplier is porcyclic in the first case, i.e. in part a, then the price level would be procyclic in part a as well.