Download Module Money, Output, and Prices in the Long Run

Pump Primer:
• Define monetary neutrality.
Module 32
Money,
Output, and
Prices in the Long Run
KRUGMAN'S
MACROECONOMICS for AP*
Margaret Ray and David Anderson
Biblical Integration:
• We are going to make mistakes because we
are all sinners, who fall short of God's glory.
However, we have to take heed and be
steadfast in our spiritual walk, "looking unto
Jesus the author and finisher of our faith" (Heb.
12:1-3). He is our example of how to overcome
destability.
What you will learn
in this Module:
• The effects of an inappropriate monetary
policy
• The concept of monetary neutrality and its
relationship to the long-term economic
effects of monetary policy
Money, Output, and Prices
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?
Money, Output, and Prices
We will consider how a counter-productive
action by a central bank can actually
destabilize the economy in the short run.
We will 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.
Short-Run and Long-Run Effects of
an Increase in the Money Supply
There are times when the central bank can
engage in monetary policy that is actually
counter-productive.
In other words, the policy might move the
economy away from potential GDP rather
than closer to potential GDP.
Short-Run and Long-Run Effects of
an Increase in the Money Supply
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 at a higher price level.
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,
but in the long
run increased
nominal wages
reduce SRAS
and lead only
to an
increased
price level.
Short-Run and Long-Run Effects of
an Increase in the Money Supply
• So in the long run, expansionary monetary
policy doesn’t increase real GDP, it only
causes inflation.
Note: If the Fed had conducted
contractionary monetary policy in the longrun, real GDP will return to potential GDP,
but the price level will have decreased.
Money Neutrality
Monetary neutrality: changes in the money
supply; has 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.
Money Neutrality
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.
Money Neutrality
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.
Money Neutrality
Changes in the Money Supply and the
Interest Rate in the Long Run
In 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.
Changes in the Money Supply and the
Interest Rate in the Long Run
Changes in the Money Supply and the
Interest Rate in the Long Run
• 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.