Module 32 Money Output & Prices in the Long Run

1. What are the effects of an inappropriate monetary policy? 2. What is the concept of monetary neutrality? 3. What is the relationship between monetary neutrality and the long-term economic effects of monetary policy?

a) Draw a correctly labeled graph of aggregate demand and supply showing the economy in macroeconomic equilibrium. b) On your graph show what happens in the short run if the Fed increases money supply to pay off government deficit. Explain. c) On your graph, show what will happen in the long run.

Increases in the money supply initially lead to an increase in output, but in the long run increased nominal wages reduce SRAS and lead only to an increased price level.

The Federal Reserve can use its monetary policy tools to change the money supply and can cause equilibrium interest rates in the money market to i___________ or d_____________. But what if a central bank pursues a monetary policy that is not appropriate (like the continual printing of currency)? How can a counter-productive action by a central bank actually destabilize the economy in the short run? What are the long-run effects of monetary policy?

The Federal Reserve can use its monetary policy tools to change the money supply and can cause equilibrium interest rates in the money market to increase or decrease. But what if a central bank pursues a monetary policy that is not appropriate? How can a counter-productive action by a central bank actually destabilize the economy in the short run? What are the long- run effects of monetary policy?  The money market determines interest rates only in the short run.  In the long run, interest rates are determined in the market for loanable funds.  The market for loanable funds is where long run adjustments and the long-run effects of monetary policy are seen.

There are times when the central bank can engage in monetary policy that is actually counterproductive. In other words, the policy might move the economy away from potential GDP rather than closer to potential GDP. Suppose the economy is currently in LR equilibrium. If the Fed were to conduct expansionary monetary policy (buy bonds), the interest rate would fall. A lower interest rate would shift AD to the right. In the short run, real GDP would increase, but so would the aggregate price level. Eventually nominal wages would rise in labor markets, shifting SRAS to the left. Long-run equilibrium would be established back at potential GDP and a higher price level. So in the long run, expansionary monetary policy doesn’t increase real GDP, it only causes inflation.

Notes:

1. Monetary neutrality: changes in the money supply have no r_______ e__________ on the economy. In the long run, the only effect of an increase in the money supply is to i_________ the aggregate price level by an e__________ percentage. 2. Economists argue that money is n__________ in the long run. 3. How does money neutrality work? 4. What difference does this make to the economy in real terms? 5. Based on money neutrality, it can be said that if the money supply increases by any given p_____________, in the long run, the aggregate price level will i_________by the same p______________.

1. Monetary neutrality: changes in the money supply have no real effects on the economy. In the long run, the only effect of an increase in the money supply is to increase the aggregate price level by an equal percentage. 2. Economists argue that money is neutral in the long run. 3. How does money neutrality work? Prices in the economy (prices of final goods and services and also factor prices, such as nominal wage rates) DOUBLE & the money supply DOUBLES at the same time. 4. What difference does this make to the economy in real terms? NONE really 5. Based on money neutrality, it can be said that if the money supply increases by any given percentage, in the long run, the aggregate price level will increase by the same percentage.

In the short run, an increase in the MS causes short-term interest rates to fall. But what happens in the long run? Suppose the money market is in equilibrium at an interest rate of i*%. Suppose MS increases by 10% to M’. The short-run interest rate falls. Money neutrality says that in the long run, the aggregate price level rises by 10%. When aggregate prices rise by 10%, households will increase their demand for money by 10%. When both MS and MD shift to the right by 10%, the long-run equilibrium interest rate returns to i*%. So in the long run, money neutrality insures that the interest rate won’t change after a change in the money supply.

 Module 32 Review Questions p.319  Read Module 33 p