Money, Output, and Prices in the Long Run AP Macro Mr. Warner

What you will learn in this Module: What would be the effects of an inappropriate monetary policy? What is money neutrality?

Short-Run and Long-Run Effects of an Increase in the Money Supply Increases in the money supply initially lead to an increase in output, The Federal Reserve can use its monetary policy tools to change the money supply and 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? We will consider how a counter-productive action by a central bank can actually destabilize the economy in the short run.   We also introduce the long-run effects of monetary policy. As we learned in the last section, the money market (where monetary policy has its effect on the money supply) determines interest rates only in the short run. In the long run, interest rates are determined in the market for loanable funds. Here we look at long run adjustments and consider the long-run effects of monetary policy. 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, 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. but in the long run increased nominal wages reduce SRAS and lead only to an increased price level.

Money Neutrality 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 raise the aggregate price level by an equal percentage. Economists argue that money is neutral in the long run.   How does money neutrality work? Suppose all prices in the economy—prices of final goods and services and also factor prices, such as nominal wage rates—double. And suppose the money supply doubles at the same time. What difference does this make to the economy in real terms? The answer is none. All real variables in the economy—such as real GDP and the real value of the money supply (the amount of goods and services it can buy)—are unchanged. So there is no reason for anyone to behave any differently. By the same intuition, we can say that if the money supply increases by any given percentage, in the long run, the aggregate price level will rise by the same percentage.

Changes in the Money Supply and the Interest Rate in the Long Run n the short run, we have seen that 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.