MONEY, OUTPUT, AND

PRICES IN THE LONG

RUN

MODULE 32

MONEY, OUTPUT, AND PRICES

Monetary policy is generally the policy

tool of choice to stabilize the economy.

In the long-run, changes in the
quantity
of
money
affect
the
aggregate price level, but they do not
change real aggregate output or the
interest rate.

SHORT-RUN AND LONG-RUN EFFECTS

OF CHANGES IN THE MONEY SUPPLY
To analyze the long-run effects of
monetary policy, it is helpful to think
of the central bank as choosing a
target for the money supply rather
than for the interest rate.
To assess the effects of changes in
the money supply, we can analyze
the long run effects of changes in AD.

SHORT-RUN AND LONG-RUN EFFECTS

OF AN INCREASE IN THE MONEY SUPPLY
An increase in the money supply
reduces the interest rate, which
increases investment spending, which
leads to a further rise in consumer
spending, and so on.
An increase in the money supply
increases the quantity of goods and
services demanded, shifting AD to the
right.

SHORT-RUN AND LONG-RUN EFFECTS

OF AN INCREASE IN THE MONEY SUPPLY
In the short run, the economy

moves to a new short run

equilibrium,
with
both
the
aggregate
price
level
and
aggregate output increasing in the
short run.
However, the aggregate output
level is above potential output.

SHORT-RUN AND LONG-RUN EFFECTS

OF AN INCREASE IN THE MONEY SUPPLY

As a result, nominal wages will

rise over time, causing the

SRAS curve to shift leftward.
This process stops when the
economy ends up at a point of
both short-run and long-run
equilibrium.

SHORT-RUN AND LONG-RUN EFFECTS

OF AN INCREASE IN THE MONEY SUPPLY

The

aggregate price level

increases, but aggregate output
is back at potential output.
So, in the long run, a monetary
expansion raises the aggregate
price level, but has no effect on
real GDP.

SHORT-RUN AND LONG-RUN EFFECTS

OF AN INCREASE IN THE MONEY SUPPLY

SHORT-RUN AND LONG-RUN EFFECTS

OF A DECREASE IN THE MONEY SUPPLY
A decrease in the money supply raises the

interest rate, which decreases investment

spending, which leads to a further
decrease in consumer spending, and so
on.
A decrease in the money supply decreases
the quantity of goods and services
demanded at any aggregate price level,
shifting the AD curve to the left.

SHORT-RUN AND LONG-RUN EFFECTS

OF A DECREASE IN THE MONEY SUPPLY
In the short run, the economy moves
to a new short-run macroeconomic
equilibrium at a level of real GDP
below potential output and a lower
aggregate price level.
Both the aggregate price level and
aggregate output decrease in the
short run.

SHORT-RUN AND LONG-RUN EFFECTS

OF A DECREASE IN THE MONEY SUPPLY
Over time, when the aggregate
output is below potential output,
nominal wages fall.
When this happens, the SRAS curve
shifts rightward.
This process stops when the economy
is at a point of both short-run and
long-run macroeconomic equilibrium.

SHORT-RUN AND LONG-RUN EFFECTS

OF A DECREASE IN THE MONEY SUPPLY
The long-run effect of a decrease in
the money supply is that the
aggregate price level decreases,
but aggregate output returns to
potential output.
In the long run, a monetary
contraction decreases the price
level, but has no effect on real GDP.

SHORT-RUN AND LONG-RUN EFFECTS

OF A DECREASE IN THE MONEY SUPPLY

MONEY NEUTRALITY
A change in the money supply leads

to a proportional change in the

aggregate price level in the long run.
If the money supply falls by 25%, the
aggregate price level falls 25% in the
long run; if the money supply rises
by 50%, the aggregate price level
rises 50% in the long run.

MONEY NEUTRALITY
If

all the prices in an economy

(prices of final goods and services,
and factor prices such as nominal
wages) double. At the same time,
suppose the money supply doubles.
This would not make any difference
to the economy, as all real variables
are unchanged.

MONEY NEUTRALITY
This is explained by:

if the economy
starts out in long-run macroeconomic
equilibrium, and the money supply
changes, in order to restore long-run
macroeconomic equilibrium, all real
values must be restored to their
original
values,
which
includes
restoring the real value of the money
supply to its original level.

MONEY NEUTRALITY
This

concept is known as money

neutrality: money is neutral in the long
run.
changes in the money supply have no real
effects on the economy in the long run.
The only effect of a change in the money
supply is to change the aggregate price
level in the same direction by an equal
percentage.

MONEY NEUTRALITY
However, in the long run, we are

all dead, so monetary policy

does have powerful real effects
on the economy in the short run,
often making the difference
between a recession and an
expansion, which matters for
societys welfare.

CHANGES IN THE MONEY SUPPLY AND

THE INTEREST RATE IN THE LONG RUN
In the short run, an increase in the

money supply leads to a fall in the

interest rate; a decrease in the
money supply leads to a rise in the
interest rate.
In the long run, however, changes
in the money supply dont affect
the interest rate at all.

CHANGES IN THE MONEY SUPPLY AND

THE INTEREST RATE IN THE LONG RUN
When the Fed increases the money supply,

the interest rate falls in the short run.

Over time, however, the aggregate price
level rises, and this raises money demand,
shifting
the
money
demand
curve
rightward.
The economy moves to a new long-run
equilibrium and the interest rate rises to its
original level.

CHANGES IN THE MONEY SUPPLY AND

THE INTEREST RATE IN THE LONG RUN
The long-run equilibrium interest rate is

the original interest rate because the

eventual increase in money demand is
proportional to the increase in money
supply,
counteracting
the
initial
downward effect on interest rates.
Changes in the money supply do not
affect the interest rate in the long run.

CHANGES IN THE MONEY SUPPLY AND

THE INTEREST RATE IN THE LONG RUN
With money neutrality, an increase

in the money supply is matched by

a proportional increase in the price
level in the long run.
The change in the aggregate price
level then cause proportional
changes in the demand for money.

CHANGES IN THE MONEY SUPPLY AND

THE INTEREST RATE IN THE LONG RUN
Example:

A 50% increase in the money supply will

raise the aggregate price level by 50%
2. This increase the quantity of money
demanded at any interest rate by 50%.
3. The quantity of money demanded rises
by as much as the money supply, and
the interest rate returns back to its
original level.
1.