The Phelps Effect, The Neutrality of Money in the...

Phelps Effect

E. Phelps offers another interpretation of events in the economy under the impact of rising prices.

Let the supply of money increase and, as a result, prices increase. The real monetary balances of individuals decreased. What will happen to wildlife?

Real money balances are part of the individual's wealth, part of his portfolio of assets. In this, Phelps agrees with Pigou. The reduction of real monetary balances causes a reduction in the total wealth of the individual. But, according to Felis, wealth does not primarily affect the savings of households, but the relative value of labor and free time of an individual.

Each individual - a potential carrier of labor - has the choice between free time, which is good for him, and work time, which is anti-good, because the burdens of work are accompanied by negative utility for a person. The tension of labor can be balanced by wages - the income that an individual spends on goods and services - on other goods.

There are two effects on the labor market - the substitution effect and the income effect.

The effect of replacement is the change in the consumption of a given product in favor of or at the expense of the consumption of another product in the consumer basket of the individual as a result of a change in the relative price of the two goods. The effect of income is the corresponding increase or decrease in consumption of a given product in the event of a fall or increase in price due to a relative change in the income of the consumer.

With respect to the labor market, the substitution effect means that the individual, with the growth of his wealth, replaces relatively expensive spare time with relatively cheap goods. The employee will strive to work harder, as this will give him the opportunity to purchase more consumer goods. As in the case of conventional goods, the substitution effect acts in the opposite direction from the price - in relation to the good - and in the same direction as the price - with respect to the anti-bargaining system that complements it.

The income effect in the case of the labor market shows the consumer's reaction in the following way. If free time is a normal commodity (and for the vast majority of people it is just so), then the growth of income under the effect of an increase in price will be accompanied by the growth of "purchases" free time and, consequently, a shorter work time. In the labor market, the substitution effect and income effect have the opposite effect on the choice of the optimal working time.

Phelps argues that the income effect for the labor market in the case of the wealth factor is prevalent. Reducing wealth leads to a decrease in demand for free time and to an increase in the supply of labor. Once the money through the Phelps effect (the effect of aggregate wealth) leads to a change in the supply of labor and aggregate output in the economy, money is not neutral.

The neutrality of money in the IS-LM model

However, a deeper analysis of the economy shows that even within the IS-LM model, money can be considered neutral.

Let the economy initially be in a long-term equilibrium, with the release of Y 1, and the real interest rate r 1 (Figure 10.11).

Neutrality of money in the IS-LM model

Fig. 10.11. Neutrality of money in the model IS-LM

The central bank increases the supply of money. Under the influence of the increased money supply, the line LM shifts to the right downwards, from the position

LM 4 to LM 2. The interest rate is decreasing. The economy moves from the point E 1 to the point E 2. A lower interest rate and expectations of further lowering the real rate (under the influence of high prices) cause an increase in investment. Since new investments appear in the economy, new investors that have not been before, the line IS shifts to the right upwards, from the position IS 1 to position IS 2. The economy shifts from the equilibrium E 2 to the equilibrium Ε 3.

However, at the point E there is an excess of aggregate demand over the aggregate supply: AD & gt; AS . The aggregate supply is represented by the line AS Ui, and the aggregate demand - by the point E 3, the equilibrium in the money and commodity markets. Since the planned expenditure of the economy (aggregate demand) exceeds its production capacity, there is an excessive demand for goods and services, under which prices start to increase. The price increase shifts the EM line to the left, from the LM 2 position to EM X. The economy moves from the point E 3 to the point E 4.

In equilibrium, E 4 interest rate is high, pessimistic expectations prevail, investors expect a further increase in the interest rate. This reduces investment. The line IS shifts to the left from the IS 2 position to IS 1. The economy returns to its original equilibrium E 1. Money is neutral, money has no impact on the real economy. Under the stimulating policy, prices only increased. The mechanism of the neutrality of money in this case is the dynamics of investment expectations.

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