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Activity 41 The neutrality of money

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Money is neutral In the long run changes in money supply will only change price level and have no change on real output

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Suppose that initially the economy is at the intersection of AD and SRAS, and the Fed decides to implement an expansionary policy to increase the level of employment In the short run, explain what happens to real output. LRAS SRAS AD REAL GDP PRICE LEVEL

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Suppose that initially the economy is at the intersection of AD and SRAS, and the Fed decides to implement an expansionary policy to increase the level of employment In the short run, explain what happens to real output. REAL OUTPUT SHOULD GROW With the decrease in interest rates because of increased MS, the interest rate sensitive components of aggregate demand (consumption and investment) will increase thereby increasing output LRAS SRAS AD REAL GDP PRICE LEVEL AD 1

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Suppose that initially the economy is at the intersection of AD and SRAS, and the Fed decides to implement an expansionary policy to increase the level of employment In the short run, explain what happens to the price level. LRAS SRAS AD REAL GDP PRICE LEVEL

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Suppose that initially the economy is at the intersection of AD and SRAS, and the Fed decides to implement an expansionary policy to increase the level of employment In the short run, explain what happens to the price level. PRICE LEVEL WILL INCREASE An increase in demand can only be met if firms have an incentive to increase production. A price increase provides that incentive LRAS SRAS AD REAL GDP PRICE LEVEL AD 1

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Suppose that initially the economy is at the intersection of AD and SRAS, and the Fed decides to implement an expansionary policy to increase the level of employment In the short run, explain what happens to employment and nominal wages. LRAS SRAS AD REAL GDP PRICE LEVEL

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Suppose that initially the economy is at the intersection of AD and SRAS, and the Fed decides to implement an expansionary policy to increase the level of employment In the short run, explain what happens to employment and nominal wages. EMPLOYMENT WILL INCREASE WHILE NOMINAL WAGES REMAIN UNCHANGED. Firms need to hire more labor to increase output while workers do not yet realize that price level has risen LRAS SRAS AD REAL GDP PRICE LEVEL AD 1

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Suppose that initially the economy is at the intersection of AD and SRAS, and the Fed decides to implement an expansionary policy to increase the level of employment In the short run, explain what happens to nominal interest rates and real interest rates. LRAS SRAS AD REAL GDP PRICE LEVEL

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Suppose that initially the economy is at the intersection of AD and SRAS, and the Fed decides to implement an expansionary policy to increase the level of employment In the short run, explain what happens to nominal interest rates and real interest rates. BOTH THE NOMINAL AND THE REAL INTEREST RATES DECLINE The increase in money supply causes nominal rates to initially decline while demand for money is constant The real interest rate (which had been equal to the nominal interest rate with no inflation) now declines because of the decrease in nominal interest rates and increase in price level Real = nominal (down) – inflation (up) LRAS SRAS AD REAL GDP PRICE LEVEL AD1

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Suppose that initially the economy is at the intersection of AD and SRAS, and the Fed decides to implement an expansionary policy to increase the level of employment In the long run, explain what happens to real output. LRAS SRAS AD REAL GDP PRICE LEVEL

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Suppose that initially the economy is at the intersection of AD and SRAS, and the Fed decides to implement an expansionary policy to increase the level of employment In the long run, explain what happens to real output. REAL OUTPUT RETURNS TO THE FULL EMPLOYMENT LEVEL As workers recognize the increased price level, they demand and get wage increases. This in turn increases production costs and short run aggregate supply decreases LRAS SRAS AD REAL GDP PRICE LEVEL AD 1 SRAS 1

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Suppose that initially the economy is at the intersection of AD and SRAS, and the Fed decides to implement an expansionary policy to increase the level of employment In the long run, explain what happens to the price level. LRAS SRAS AD REAL GDP PRICE LEVEL

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Suppose that initially the economy is at the intersection of AD and SRAS, and the Fed decides to implement an expansionary policy to increase the level of employment In the long run, explain what happens to the price level. PRICE LEVEL REMAINS HIGH Nominal wages are now in alignment with the higher price level LRAS SRAS AD REAL GDP PRICE LEVEL AD 1 SRAS 1

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Suppose that initially the economy is at the intersection of AD and SRAS, and the Fed decides to implement an expansionary policy to increase the level of employment In the long run, explain what happens to employment and nominal wages. LRAS SRAS AD REAL GDP PRICE LEVEL

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Suppose that initially the economy is at the intersection of AD and SRAS, and the Fed decides to implement an expansionary policy to increase the level of employment In the long run, explain what happens to employment and nominal wages. EMPLOYMENT IS AT THE FULL EMPLOYMENT LEVEL AND NOMINAL WAGES HAVE RISEN Nominal wages rise so that real wages given them the same purchasing power LRAS SRAS AD REAL GDP PRICE LEVEL SRAS 1 AD 1

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Suppose that initially the economy is at the intersection of AD and SRAS, and the Fed decides to implement an expansionary policy to increase the level of employment In the long run, explain what happens to the nominal interest rate and the real interest rate. LRAS SRAS AD REAL GDP PRICE LEVEL

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Suppose that initially the economy is at the intersection of AD and SRAS, and the Fed decides to implement an expansionary policy to increase the level of employment In the long run, explain what happens to the nominal interest rate and the real interest rate. The real interest rate returns to its normal level (in the US between 2% and 3%). Nominal rates rise to include the inflation rate and the real interest rate LRAS SRAS AD REAL GDP PRICE LEVEL

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