Chapter 19 Organisation of the chapter This chapter is new for this edition, and brings together the analysis of the goods and money markets to show how changes in the one market will affect the other market and how an overall equilibrium will be formed. Parts of the chapter draw on material in the old Chapter 20 (sections 20.1, 20.2 and 20.3) and part on the old Chapter 18, section 18.5. This new structure, I feel, makes the analysis more transparent and provides a firm basis for the analysis of fiscal and monetary policy in Chapter 20. Section 19.1 shows how change in the money market affect the goods market. It starts by rooting the discussion in terms of the quantity theory of money and shows that the effect of monetary changes on real national income and on prices depends on assumptions about the variability of the velocity of circulation. It then goes on to examine the two key transmission mechanisms: the interest rate transmission mechanism and the exchange rate transmission mechanism. This second mechanism is rarely discussed in introductory texts, but I believe that students would get a quite false impression of the effects of monetary changes in the real world of open economies if the analysis were confined to the first mechanism. The section also looks at the theory of portfolio balance. Section 19.2 looks at the reverse relationship: namely, the effect of changes in the goods market on the money market and how these effects on the money market constrain the goods market changes. It provides an analysis of crowding out and finishes with a discussion of the importance of assumptions about whether money supply is exogenous or endogenous. These first two sections set the scene for Chapter 20’s analysis of the relative effectiveness of fiscal and monetary policies. Section 19.3 (which is optional) looks at ISLM analysis. The coverage here is more detailed than in most introductory texts, and the student is shown how the analysis can be used to demonstrate the relative strength of the effects of changes in the goods and money markets under different assumptions about the shapes of the IS and LM curves. Despite being fairly detailed, the exposition is kept as straightforward as possible, and beginning students should have no difficulty in handling the concepts or the analysis. The theory developed in this section is used as the basis for section 20.5 (also optional), which uses ISLM analysis to consider the relative effectiveness of fiscal and monetary policy. Section 19.4, which is totally new for this edition, develops the aggregate demand and supply model to show the relationship between money and goods markets when inflation is targeted. The model, developed by Taylor and Romer (see, for example, http://www.nber.org/papers/w7461.pdf) has inflation on the vertical axis, rather than the price level and is thus appropriate for the context in which inflation is targeted. The treatment of the model is straightforward and, unlike the Taylor treatment, incorporates an aggregate supply curve. Students should have no difficulties in getting to grips with the model as the explanation is carefully structured. The section uses the model to analyse the effects of changes in aggregate demand and supply. Despite the model’s usefulness in this particular context, it is less universal than the traditional aggregate demand and supply model and is based on very restrictive assumptions about the nature of shifts and movements along the ADI curve, depending on whether interest rate changes represent changes in response to being off the inflation target or changes in the target rate of interest. For this reason, I have retained the traditional AD/AS model other than when discussing the context of inflation targets. Variations in the use of the chapter material The amount you choose to use this chapter depends on how advanced and how applied your course is. Most beginning students, should be able to cope with the material, but it will demand time devoted to it. Sections 19.1 and 19.2 form a pair and ought normally to be studied together or omitted, although it would be possible to view section 19.1 as an extension of section 18.5, in which case you could omit 2 Tutor’s Guide to Economics (5th edition) John Sloman section 19.2. Alternatively section 19.2 could be regarded as an introduction to section 20.2 (on fiscal policy), in which case section 19.1 could be omitted or studied before section 20.3. The most obvious candidate for omission is section 19.3 on ISLM analysis: Chapter 20 follows on perfectly satisfactorily from section 19.2 (or 19.4). A knowledge of ISLM analysis will only be required later in the book if your students study the optional section 20.5 or the open economy ISLMBP appendix to Chapter 24 You can also omit section 19.4 (but would need to omit the relevant passage on the Taylor rule on page 584). Alternatively, students could study section 19.4 directly before section 20.7. It should be clear from the above that the material in the chapter can be used as you see fit and tailored to your particular course. Learning objectives By the end of the respective section, the students should be able to do the following: Section 19.1 The effects of monetary changes on real national income • Give the quantity equation, MV = PY and explain the terms and the significance of the equation being an identity rather than an equilibrium condition. • Explain the significance of the degree of stability of V and Y for the effects of changes in the money supply on the economy. • Describe the interest-rate transmission mechanism and, in terms of the mechanism, identify what determines the size of changes in national income resulting from changes in money supply. • Explain the Keynesian views about (a) the elasticity and instability of the liquidity preference curve, and (b) the interest inelasticity and instability of investment demand, and explain why they should make the link between changes in money supply and changes in aggregate demand both weak and uncertain. • Describe the exchange-rate transmission mechanism and, in terms of this mechanism, identify what determines the size of changes in national income resulting from changes in money supply. • Explain the monetarist/new classical views about both the direct and indirect monetary transmission mechanisms, and why such economists believe that changes in money supply are likely to have a powerful effect, and why the demand for money is likely to be stable, at least in the long run. • Use the analysis of the section to explain the degree of variability of the velocity of circulation, in both the short and long run. Section 19.2 The monetary effects of changes in the goods market • Explain the monetary effects of an increase in injections and what determines the size of the resulting equilibrium interest rate change. • Using liquidity preference and investment demand diagrams, explain what is meant by financial crowding out and what determines its extent. • Distinguish between Keynesian and monetarist views on crowding out. • Understand what determines the degree of endogeneity of money supply and describe different views on whether money supply is endogenous or exogenous. Section *19.3 ISLM analysis: the integration of the goods and money market models • Distinguish between the goods and money market and describe equilibrium in each separately using a Keynesian I and S (J and W) diagram and a demand for and supply of money diagram. • Show how the IS curve is derived in the ISLM model and describe the factors that determine its elasticity, and what causes the curve to shift. • Show how the LM curve is derived in the ISLM model and describe the factors that determine its elasticity, and what causes the curve to shift. Guide to using each chapter 3 • Describe how equilibrium is formed in the model, and analyse the effects of shifts in either or both curves. • Derive an aggregate demand curve from an ISLM diagram. Section 19.4 Taking inflation into account • Construct an ADI / ASI diagram, including an inflation target line. • Describe what determines the shape of the ADI and ASI curves. • Explain what would cause a movement along and a shift in each of the three lines. • Use the model to analyse the effects of changes in aggregate demand when inflation is targeted. • Use the model to analyse the effects of temporary supply shocks and permanent changes in aggregate supply.
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