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Intermediate Macroeconomics


8. General Equilibrium Model with Money


In this section we incorporate the market for money (Section 7)into the dynamic general equilibrium model (Section 5). The result is a dynamic general equilibrium model that includes equilibrium outcomes for the aggregate price level and introduces the a limited role for monetary policy. We describe and illustrate the some of the economic conditions which cause monetary policy to have real effects on the economy versus only nominal effects (affecting only the aggregate price level, but no real variable such as employment or real GDP).


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Framework

We begin by introducing the framework for our general equilibrium intertemporal monetary model. The framework includes a market for labor which determined equilibrium employment and wages, a production function which along with the equilibrium level of employment determines production, a market for final goods and services which determines the equilibrium interest rate and real GDP, a market for money which determines the aggregate price level and quantity of the nominal money supply, and demand curves for consumption and investment which determined each of these equilibrium quantities given the equilibrium interest rate. The Pencasts that follow use this framework to examine general equilibrium consequences to changes in the economy. [Play Pencast]


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Drop in Consumption Demand

Here we examine the general equilibrium consequences to a drop in consumption demand. This could be caused when there is a change in consumer preferences such that consumers choose to save more, prefering to have more future consumption versus in the present. We look at the general equilibrium outcomes for real wages, the real interest rate, the aggregate price level, employment, real GDP, consumption, and investment. [Play Pencast]


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Improvement in Productivity

Here we examine the general equilibrium effects from a temporary improvement in total factor productivity. With a temporary improvement in productivity, we imagine a situation in which capital and labor are more productive in the present period, but there is not necessarily an expectation for this to continue into the future. An example might include good weather or climate which can affect important production sectors such as agriculture and construction. We look at the general equilibrium outcomes for real wages, the real interest rate, the aggregate price level, employment, real GDP, consumption, and investment. [Play Pencast]


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Money Neutrality

Money neutrality is the result that changes in money supply only affect the aggregate price level and otherwise affect no other variable in the economy. All real variables that are of value to consumers or firms are unchanged. These include the real wage, the real interest rate, employment, real GDP, consumption, and investment. We demonstrate the money neutrality result in our dynamic general equilibrium model. One key assumption driving this outcome is that all prices are fully flexible. This means the nominal wage and the aggregate price level immediately adjust to appropriate levels should the equilibrium outcome change. We also assume that consumers are fully informed on nominal and real prices. In this Pencast, we suppose the central bank increases the money supply and we use the dynamic general equilibrium model to illustrate these very limited consequences. [Play Pencast]


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Money Surprises

Here we investigate a case in which monetary policy is not neutral. We increase the money supply and show real consequences to employment, real GDP, and other variables in an environment where consumers are not perfectly informed on nominal and real prices. As in the previous Pencast, the increase in money supply causes an increase in price level and no change to real wage. This implies the nominal wage increases by the same proportion as the price level. The ill-informed consumer misinterprets his/her nominal wage increase as an increase in the real wage and chooses to work more in response. We describe and illustrate the equilibrium outcomes for real wages, the real interest rate, the aggregate price level, employment, real GDP, consumption, and investment. [Play Pencast]


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