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>> Monetary Policy Section 4: Money, Output, and Prices in the Long Run chapter 14 Through its expansionary and contractionary effects, monetary policy can be used to move the economy more quickly to long-run macroeconomic equilibrium. Sometimes, however, there are monetary events that move the economy away from long-run macroeconomic equilibrium. Sometimes the central bank simply makes a mistake. For example, it may believe that potential output is higher or lower than it really is and implement a misguided monetary policy. In addition, central banks are sometimes forced to pursue considerations other than stabilizing the economy. For example, as we’ll see in Chapter 16, central banks sometimes help the government pay its bills by printing money, an action that increases the money supply. What happens when a change in the money supply pushes the economy away from, rather than toward, long-run equilibrium? We learned in Chapter 10 that the econo- my is self-correcting in the long run: a demand shock has only a temporary effect on aggregate output. If the demand shock is the result of a change in the money supply,
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2 CHAPTER 14 SECTION 4: MONEY, OUTPUT, AND PRICES IN THE LONG RUN we can make a stronger statement: 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. To see why, let’s look at the case of an increase in the money supply. Short-Run and Long-Run Effects of an Increase in the Money Supply To analyze the long-run effects of an increase in the money supply, we recall the dis- tinction between the short-run and long-run aggregate supply curves. The short-run aggregate supply curve slopes upward: in the short run, a higher aggregate price level leads to higher production. The long-run aggregate supply curve, however, is vertical at potential output: in the long run, a rise in prices of final goods and services leads to an equal rise in nominal wages, and real GDP remains equal to potential output. Figure 14-11 shows the short-run and long-run effects of an increase in the money supply when the economy begins at potential output, Y 1 . The initial short-run aggregate supply curve is SRAS 1 , the long-run aggregate supply curve is LRAS, and the initial aggre- gate demand curve is AD 1 . The economy’s initial equilibrium is at E 1 , a point of both short-run and long-run macroeconomic equilibrium because it is on both the short-run and the long-run aggregate supply curves. Real GDP is at potential output, Y 1 . Now suppose there is an increase in the money supply. This shifts the AD curve to the right, to AD 2 . In the short run, the economy moves to a new short-run macro- economic equilibrium at E 2 . The price level rises from P 1 to P 2 , and real GDP rises from Y 1 to Y 2 . That is, both the aggregate price level and aggregate output increase in the short run. But the aggregate output level
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This note was uploaded on 04/10/2008 for the course ECONOMICS 103 taught by Professor Sheflin during the Spring '08 term at Rutgers.

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