Phillips Curve central, interest, decrease, following, employment

ShooterMcCFA

Cant make head or tail of the following sentence in Schweser on page 173

"When a central bank unexpectedly decreases the rate of money supply growth to reduce inflation, the initial effect is to decrease aggregate supply as real wages rise resulting in a short run decrease in both GDP and employment. In this case, actual inflation is less than anticipated inflation and unemployment increases as a result"

My thinking:

When money supply decreases, interest rates rise, and aggregate demand falls. This reduces prices (inflation) and increases unemployment.

Anyway If I were to accept that a change in aggregate supply is the "initial effect", how ther hell is actual inflation less? Prices RISE when aggregate supply falls.

Anybody?

Londonrocks

the absolute distance between your real GDP and potential GDP is going to reduce and hence the natural unemployment increases.

Kiakaha

"My thinking:

When money supply decreases, interest rates rise, and aggregate demand falls. This reduces prices (inflation) and increases unemployment. "

When money supply decreases = consumers will spend less = producers will seek to hire less & produce less = decrease in aggregate supply.

A reduction in prices is not inflation, rather it is deflation. << I assume you know that.

pacmandefense

Damil:

When money supply decreases = consumers will spend less = producers will seek to hire less & produce less = decrease in aggregate supply. << I don't think so. When consumption expenditure falls, aggregate demand falls. You can say that aggregate supply falls when aggregate demand falls. There's just a movement along the agregate supply curve to a lower price level with higher unemployment.

Schweser is totally wrong here. The only effects of an increase in real interest rates on agregate supply is that agregate supply INCREASES (not decreases as schweser insists). See- real business cycle theory from the curriculum.

Any helpers?

Flok

It is a matter of expectations versus actual. Their is an unexpected decrease in the money supply growth. The wages in the short run are fixed and based upon the expected inflation being higher than actual inflation due to the unexpected decrease in money supply growth. The workers benefit relative to the firm. Their real wages increase. Because real wages increase, supply (of labor) will decrease, increasing unemployment.

lc26mizzou

"Because real wages increase, supply (of labor) will decrease, increasing unemployment."
<<< When real wages increase, labor supply increases (upward sloping supply curve)

I think the point you're trying to make is that more people are willing to work and this increases unemplyoment.

Either way, why does agregate supply fall? (see quote from schweser above)

dece2011

I think AndrewP has got it correctly, except his last line.

"It is a matter of expectations versus actual. Their is an unexpected decrease in the money supply growth. The wages in the short run are fixed and based upon the expected inflation being higher than actual inflation due to the unexpected decrease in money supply growth. The workers benefit relative to the firm. Their real wages increase. Because real wages increase, supply (of labor) will decrease, increasing unemployment."

Last line should have been, "Because real wages increase, demand (of labor) will decrease, increasing unemployment."

mnieman

Ok I understand AndrewP's point now rus, but the questions remains:

"When a central bank unexpectedly decreases the rate of money supply growth to reduce inflation, the initial effect is to decrease aggregate supply as real wages rise." HOW??

Monetary policy has an effect on aggregate demand. I haven't read of any supply side effects on monetary policy.

Finalnub

akshayj,

----
>"When a central bank unexpectedly decreases the rate of money supply growth to >reduce inflation, the initial effect is to decrease aggregate supply as real wages rise." >HOW
----

The key here is 'unexpected' decrease of money supply.

See, 'unexpected' or 'expected', decrease in money supply will reduce inflation, right?

But, had the reduction in inflation been anticipated, say months in advance, then companies would have reduced nominal wages of their workers accordingly (not affecting their real wages though) and would have kept the same level of employment.

Since, here the reduction in inflation is 'unexpected', in the short term companies cannot reduce nominal wages quickly, meaning there is a raise in real wages of employees. Now, there are 2 ways of coping this by companies. 1) Reduce nominal wages, which they cannot as this has come unexpectedly. 2) Retrench. They would go for 2nd option in short term and hence an increase in unemployment along with decrease in GDP.

So, 'unexpected' reduction in money supply will also affect the supply side in such manner.

Hope this helps.

homie

I see your point. But its only a movement along the supply curve then. Calling it a shift in aggregate supply (which I think Schweser is implying) would be wrong....