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Macroeconomic Theory and Policy

Macroeconomic Theory and Policy


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Published by: mriley@gmail.com on Nov 03, 2008
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Traditionally, most macroeconomic models that include money view things from
an opposite extreme; i.e., under the assumption that the economy’s money
supply is created (or at least controlled) by the government (instead of the
private sector). In the context of the models described above, this change in
perspective turns out to be innocuous.
Consider, for example, the neoclassical labor market model. Here we can
imagine that the government creates Mt dollars of money and either lends or
gives it to the business sector. The business sector then uses this money to
purchase labor and households subsequently use their money income to purchase
output. Since Mt is viewed as exogenous, the equilibrium price-level is given

Pt = Mt

yt ;


with the nominal wage being determined by Wt = zt/Pt .
Likewise, in the context of the Wicksellian model, imagine that the govern-
ment creates M units of money and then lends it to the A individual. The
sequence of exchanges may now proceed on a sequence of spot markets where
goods trade for government money. The equilibrium price-level at each date is
given by Pt = M/yt.

The only ‘benefit’ of viewing things in this manner is that equilibrium nom-
inal variables are now determinate (by assuming that Mt is exogenous). In
particular, the price-level (and inflation) is now under control of government
policy. Whether this view holds in reality, however, depends on the extent to
which government policy may actually control the economy’s money supply. As
I mentioned earlier, in reality, most of an economy’s supply (i.e., that part that
does not constitute paper) is created by the private sector.

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