Question

a) Show that it is possible in a model with expectations (e.g. using the new classical model) for an increase in the money supply to reduce output if the change in the money supply is smaller than expected.

b) Compare and contrast the effects of an unexpected increase or decrease in the money supply on prices and output in the New Classical and New Keynesian models.

ci) Do monetarist agree with Friedman’s Contention that inflation is always and everywhere a monetary phenomenon? Explain with the AD – AS model.

ii) Do Keynesians agree with Friedman’s Contention that inflation is always and everywhere a monetary phenomenon? Explain using the AD – AS model.

Answer 1

( a ).

The increase in the money supply shifts the aggregate demand schedule from Yd ( Mo,.....) to Yd ( M1,....). By itself, this change would increase output to Y1' and the price level to P1'. The increase in the price level would shift the labor demand curve to the right, and employment would rise. However, because the increase in the money supply was anticipated, there is also an increase in the expected money supply. This increase shifts the aggregate supply curve to the left and also shifts the labor supply curve to the left. These shifts cause employment and output to fall back from their earlier position if actual money supply is less than expected supply of money.

B.

When the increase or decrease in the money supply is not anticipated, it does not affect the labor suppliers' expectation of the value the aggregate price level will take on over the current period, so the labor supply schedule does not shift.

When the increase in the money supply is unanticipated, the new classical model indicates that output and employment will be effected. The results in output and employment are identical to those of the Keynesian or monetarist analysis of such an increase in aggregate demand. New classical economists deny that anticipated changes in aggregate demand can affect output and employment, but their view of the effects of unanticipated changes in aggregate demand does not differ from that of Keynesians and monetarists.

C.

Yes, monetarist agree with Friedman's Contention that inflation is always and everywhere a monetary phenomenon.

Following a rise in the money supply, consumers have more money and therefore spend more money on goods; this shifts AD to the right. AD1 to AD2.

Firms respond by increasing output along SRAS. Real output increases from Y1 to Y2.

National output now exceeds the equilibrium level of output. There is an inflationary gap. Firms hire more workers, so wages rise leading to increase in costs and hence prices. Workers realize the increase in nominal wage is not real wage increase. Therefore, workers also demand higher nominal wages to produce more output and to compensate them for rising prices, therefore SRAS shifts to the left.

The economy has returned to the equilibrium level of output ( Y1 ), but at higher price level ( P3 ).

( ii ).

No, Keynesians don't agree with Friedman's contention that inflation is always and everywhere a monetary phenomenon.

Keynes postulated that the money supply had an influence on inflation in a much more complex way than the strict monetarists suggested.
Instead Keynes proposed that inflation was caused in number of different ways:

• By demand outstripping supply and pulling inflation higher
• By inflation being built into the system
• By higher costs pushing inflation higher.