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Monetary policy and the AD relation

The AD relation showed a downward sloping relationship between output and prices. The mechanism was really working through real money balances $\frac{M}{P}$, ie when prices rose, if the nominal money stock, M, stayed constant, then real money balances fell.

The opposite of that is what happens if (in the short run) prices stay constant and the money stock rises. Then real money balances will rise, so the analysis used for the AD relation would suggest that output would rise. If prices are constant then increasing the money stock represents a shift up of the LM curve, while decreasing the money stock represents a shift down of the LM curve. This is a simple way to think about monetary policy, a monetary expansion is increasing the money stock, a monetary contraction is decreasing the money stock.

Remember what influences the AD curve:

The AD curve tells you the equilibrium level of output in the goods and money markets, for any given price level. Anything which will change the equilibrium level of output at all price levels, will shift the whole AD curve. So you can basically think of this as anything ‘happening’ in the ISLM model which will cause the equilibrium level of output to change apart from a change in the price level, which is captured in the downward slope of the AD line.

So the AD curve shifts out to the right, if you have a fiscal expansion or a monetary expansion, or anything that will increase consumer confidence to encourage consumers to spend more (which means the IS curve shifts out just like the fiscal expansion)

The AD curve shifts in to the left, if you have a fiscal contraction or a monetary contraction, or anything that will decrease consumer confidence to cause consumers to spend less (which means the IS curve shifts in just like the fiscal contraction)

So we can express a relationship between output and monetary and fiscal policy like this: $Y_t = \gamma[\frac{M_t}{P_t}, G_t, T_t]$.

This is saying output is equal to a parameter multiplied by a function of monetary and fiscal policy. Now if we want to isolate the way monetary policy influences output, keep fiscal policy constant and forget about G and T.

$Y_t = \gamma[\frac{M_t}{P_t}]$.

In terms of growth you can use an approximation that if $Y_t = \gamma \frac{M_t}{P_t}$ then $g_{yt} \approx g_{mt} - g_{pt}$. Note that growth in prices in year t is inflation in year t, so $g_{yt} \approx g_{mt} - \pi_t$.

We can rearrange this to say $\pi_t \approx g_{mt} - g_{yt}$. This is a useful way of thinking about the relationship between inflation and money growth, it says that inflation in year 1 will be approximately equal to the rate of money growth minus the rate of output growth. This is basically because if the economy grows, there will be a growing level of transactions, and so a growing demand for real money. The real money stock always grows at the same rate that output grows. As the real money stock is $\frac{M}{P}$ then if M grows at a different rate to output, the difference will be made up by changes in P. If the rate of money growth matches the rate of output growth you will have stable prices and no inflation. This sounds deceptively easy and in reality inflation is easy to stop, if you turn the taps of money growth off, inflation will soon judder to a halt, the reason that isn’t done in practice is that that approach would have a seriously detrimental effect on output as it would mean there was not enough money around to support the level of transactions demanded, so the lack of money would trigger a recession.