Wednesday, April 18, 2007

Another Teachable Moment

Economists from KNZN, to Byran Kaplan to apparently Greg Mankiw have stopped by Modeled in the past. I am hoping to catch one of them or anyone else in the blogosphere who can explain the following quandary to me.

How can we feel comfortable assuming that increases in the money supply feed directly into increases in nominal demand?

Here is the quandary as it occurs to me. Increases in nominal demand lead to increases in prices. But don't we need increases in prices to see increases nominal demand?

Suppose that we live in an economy with no technological growth and no population change so that every period is the same as the one before. There is a constant money supply until time some time t0.

At t0 the money supply doubles. At this particular moment nothing has happened to prices. So everyone has just received a real increase in their transitory income. They should then attempt to smooth it out by saving it.

This drives down the interest rate. This should encourage accumulation of more capital and an increase in consumption and as such an increase in aggregate demand. Yet, I see no reason to suppose that the increase in demand would be proportionate.

Capital and consumer durables should be favored. Furthermore, there are those who posses scare inputs in the production of these goods. They should see real increases in relative demand. This should lead to an increase in their demand for labor.

It seems that price increases for the rest of the economy should come primarily from labor moving into the durables market away from non-durables. This run up in price would decrease the value of the extra money leading to a slow unraveling of this process.


However, I cannot see how it is in any one's interest to raise prices before they face a decrease in labor supply, nor how it is in the interest of the consumer to spend more on non-durables before the price goes up. It would seem that the whole thing has to work its way through the durables market.

Furthermore, as long as there is some time cost associated with changing jobs this process will take time.

As far as I can tell this seems largely consistent with what happens in the world. What is wrong with my story?

Update: Just to be clear. This is a geniune question not a see who can get the answer question.

15 comments:

pickster2021 said...

"Increases in nominal demand lead to increases in prices. But don't we need increases in prices to see increases nominal demand?"

Wouldnt it depend on the elasticity of demand?

pickster2021 said...

also, is it sufficient or necessary that prices must increase to see an increase in demand? It may follow that prices do rise due to demand, but it may not be necessary depending on the elasticity of the demand.

It seems to me that an increase in the money supply can act, in a way, as a subsidy on the market. The subsidy can be equally proportionate among both the producer and the consumer, or depending on the elasticity of demand it can be placed squarely on one or the other.

i could, however, be way off base from the question.

Gabriel Mihalache said...

If you're willing to see saving/investing as just another good on which you can spend money on, and the interest rate as any other price, then your question is one of accounting identities. Every dollar goes either in private consumption, either in private investment, either in imports or in government expenditure. All together, those are aggregate demand.

If by nominal demand you mean demand for a particular class of goods, private consumption + government expenditure, then the split between consumption and saving can be studied with the permanent income/life cycle hypothesis.

An increase in the money supply increases nominal purchasing power.

But maybe I don't understand your question...

Karl Smith said...

An increase in the money supply increases nominal purchasing power.

So a common train of thought is that while more money means more nominal purchasing power it doesn't mean an increase in real demand.

However, doesn't mean an increase in the real demand for consumer durables?

If increases in the money supply are intially "saved" then money should have a real impact on investment.

This is my point. It is important because the non-neutrality of money is supposed to be a quandry.

Gabriel Mihalache said...

Huh... if it's saved then the nominal interest rate changes and clears the loanable funds market. You could argue that more projects would get invested in, at old prices, than before, but you need some assumptions about expectations, if everyone can observe the monetary mass.

If you're committed to market clearing as a modeling strategy then you need something like the Lucas islands model or some sort of stickiness to get short-term non-neutrality.

In Hume's account of long-run neutrality and short-run non-neutrality, the new money worked its way through th economy, pushing prices up as it went round and round. His story was credible because people didn't observe the increase in the monetary mass.

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