We discussed the business cycle fact that money is a pro-cyclical economic statistic.
a) First, explain how the real business cycle theorists explain the pro-cyclical behavior of money. In the space below, draw three diagrams, a money market diagram, an IS - LM - FE diagram, and an aggregate demand - aggregate supply diagram. Start at point A and describe how the business cycle theorists explain the fact that money is leading and pro-cyclical as we move from point A to point B. Be sure to explain the move from point A to B in all three diagrams. Now show what would happen if the Fed did nothing and label as points C. Is this result desirable, why or why not? Do the real business cycle theorists believe that it is a good idea to fight recessions with expansionary monetary policy as defined by increases in M? Why or why not? Explain.
b) Now explain how the New Keynesians explain the pro-cyclical behavior of money. In the space below, draw a money market diagram, an IS - LM - FE diagram, and savings - investment diagram, an IS, LM, FE diagram, and an aggregate demand - aggregate supply diagram. Start at point A and allow the increase in M to move us to point B. Be sure to label all your diagrams completely. What does the power of expansionary monetary policy depend on? Be sure to mention the state of the economy in your discussion.