Lecture 17Money and Business CyclesNoah WilliamsUniversity of Wisconsin - MadisonEconomics 312Spring 2010Williams Economics 312Money and Business CyclesRelation between output and money. Money ispro-cyclical, more so prior to 1985.Phillips Curve: tend to observe negative relationshipbetween inflation rate and unemployment rate.Relationship not stable.Other pieces of evidence:- Volcker’s recessions: Tightening of monetary policy inearly 1980s seemed to lead to recessions.- Friedman and Schwartz (1963), A Monetary History ofthe United States: independent fluctuations in moneysupply were followed by changes in real output.Williams Economics 312Copyright © 2008 Pearson Addison-Wesley. All rights reserved.3-19Figure 3.13 Percentage Deviations from Trend in the Money Supply (black line) and Real GDP(colored line) for the Period 1959–2006.Williams Economics 312Growth in M1 and GDPWilliams Economics 312Unemployment Rate and CPI Inflation RateWilliams Economics 312Phillips Curve, 1956-20043 4 5 6 7 8 9 1002468101214UnemploymentInflationPhillips Curve: 1956−2004Williams Economics 312Phillips Curve, 1960-19693 4 5 6 7 8 9 1002468101214UnemploymentInflationPhillips Curve: 1960−1969Williams Economics 312Phillips Curve, 1976-19793 4 5 6 7 8 9 1002468101214Phillips Curve: 1976−1979UnemploymentInflationWilliams Economics 312Phillips Curve, 1993-20003 4 5 6 7 8 9 1002468101214UnemploymentInflationPhillips Curve: 1993−2000Williams Economics 312Modeling Monetary Business CyclesIn model so far money is neutral. Change in money has noeffect on economic activity.Seems to hold in long-run, less so in short run. How toreconcile?Response #1: RBC denial. Evidence of effect of money isnot causal. Observe M leading Y but also observe carryingof umbrellas leading rainfall. Increase in M may reflectexpectations of higher future Y .Response #2: Lucas (1972) imperfect-information model.Short-run effects of money supply caused by confusingchanges in relative and aggregate prices. More on this next.Response #3: Keynesian and New-Keynesian: nominalrigidities. Some prices and wages fixed for a period of time.Changes in money then change real wages. More later.Williams Economics 312Copyright © 2005 Pearson Addison-Wesley. All rights reserved.11-8Figure 11.5 Procyclical Money Supply in the Real Business Cycle Model with Endogenous MoneyWilliams Economics 312Imperfect-Information Model ISeen some evidence that money is not neutral in theshort-run. First: Why is money not neutral in aflexible-price economy?Model due to Lucas (1972). Misperceptions of changes inmoney may have real effects.Household makes labor supply decisions based on the realwage:w =WPSuppose that the substitution effect dominates in eachperiod because of intertemporal substitution:N0(w) > 0Household observes nominal wage W .Williams Economics 312Imperfect-Information Model IIEconomy is hit by shocks to productivity A (that raise w)and to the money supply (that raise P).With perfect information on P (or M ), household justfinds:w =WPand takes labor supply decisions.But what happens if P or M are not observed?Williams Economics 312Imperfect-Information Model IIIThe household observes W going up.Signal extraction problem: Must decide if W goes upbecause P goes up (since W = wp) or because w went up.Response is different. Both shocks (typically) increasenominal labor demand.Nominal labor supply should respond (more) to a moneyshock.But workers are forced to respond equally to both shocks,since don’t know which has happened.Williams Economics 312Increase in Money Supply Persistent Increase in ProductivityNwLsLdNwLsLdNWLsLdNWLsLdNominal labor demand is similar, but labor supply should not be.63Williams Economics 312Labor supply is given by an average of the desired responses.NWLsLd• Smaller response of employment to a productivity shock.• Larger response of employment to a money shock.64Williams Economics 312Effects of ShocksAn anticipated change in money is neutral: as last time.An unanticipated one-time increase in the money supply:Employment and hence output supply increases.A similar logic implies output demand increases slightly.Output increases and real interest rates fall.Real money demand increases.The price level increases (but less than if money neutral).Once change in money is realized, real economy reverts toold levels with higher prices. Money is neutral in long-run.A productivity shock is qualitatively as in the RBC model.Output supply increases by more than output demand.Output increases and real interest rates fall.Real money demand increases. Price level declines.Williams Economics 312Copyright © 2005 Pearson Addison-Wesley. All rights reserved.11-2Figure 11.1 The Effects of an Unanticipated Increase in the Money Supply in the Money Surprise ModelWilliams Economics 312ImplicationsThen money supply surprises affect labor supply and withit total output. As output increases above expected level,unemployment decreases. Get an expectations-augmentedPhillips curve.There is a fundamental natural unemployment rate ¯u inthe economy, depending on labor market institutions.(More on this later in class.)Idea dates to Friedman (1968) and Phelps (1968): Thecyclical unemployment rate u − ¯u depends onunanticipated inflation:i = ie− h(u − ¯u)When i = ie, u = ¯u. When i > ie, u < ¯u.Williams Economics 312Shifting Phillips CurveThe Phillips curve shows the relationship betweenunemployment and inflation for a given expected rate ofinflation and natural rate of unemployment.Relationship between i and u isn’t stable when ¯u or iechange:- Higher ieimplies a higher Phillips curve.- Higher ¯u shifts Phillips curve to the right.A fall in TFP increases both expected inflation and thenatural rate of unemployment. Shifts the Phillips curve upand to the right. Phillips curve unstable in periods withlarge TFP shocks.Williams Economics 312Abel/Bernanke, Macroeconomics, © 2001 Addison Wesley Longman, Inc. All rights reservedFigure 12.05 The shifting Phillips curve: an increase in expected inflationWilliams Economics 312Abel/Bernanke, Macroeconomics, © 2001 Addison Wesley Longman, Inc. All rights reservedFigure 12.06 The shifting Phillips curve: an increase in the natural unemployment rateWilliams Economics 312Historical Shifts in Phillips CurveUS in 1960s: expected inflation and the natural rate ofunemployment are approximately constant. Stable Phillipscurve.After 1970: expected inflation rate and the natural rate