KRUGMAN_WELLS_MACRO_CHAPTER14

Here the economy begins at e1 a point of short run

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Unformatted text preview: nary Edition Figure CHAPTER 14 M O N E TA R Y P O L I C Y 361 14-13 The Short-Run and Long-Run Effects of an Increase in the Money Supply An increase in the money supply generates a positive short-run effect, but no long-run effect, on real GDP. Here, the economy begins at E1, a point of short-run and long-run equilibrium. An increase in the money supply shifts the AD curve rightward, and the economy moves to a new short-run equilibrium at E2 and a new real GDP of Y2. But E2 is not a long-run equilibrium: Y2 exceeds potential output, Y1, inducing over time an increase in nominal wages in the economy. In the long-run, the increase in nominal wages will shift the short-run aggregate supply curve leftward, to a new position at SRAS2. The economy reaches a new short-run and long-run equilibrium at E3 on the LRAS curve, and output falls back to potential output, Y1. The only long-run effect of an increase in the money supply is an increase in the aggregate price level, to P3. Aggregate price level An increase in the money supply reduces the interest rate and increases aggregate demand . . . LRAS SRAS2 SRAS1 E3 P3 P2 E2 P1 E1 Potential output Y1 both the short-run and the long-run aggregate supply curves. Real GDP is at potential output, Y1. Now suppose there is an increase in the money supply. This shifts the AD curve to the right, to AD2. In the short run, the economy moves to a new short-run macroeconomic equilibrium at E2. The price level rises from P1 to P2, and real GDP rises from Y1 to Y2. That is, both the aggregate price level and aggregate output increase in the short run. But the aggregate output level Y2 is above potential output. As a result, nominal wages will rise over time, causing the short-run aggregate supply curve to shift leftward. This process stops only when the SRAS curve ends up at SRAS2 and the economy ends up at point E3, a point of both short-run and long-run macroeconomic equilibrium. The long-run effect of an increase in the money supply, then, is that the aggregate price level has increased from P1 to P3, but aggregate output is back at potential output, Y1. In the long run, a monetary expansion raises the aggregate price level but has no effect on real GDP. We won’t describe the effects of a monetary contraction in detail, but the same logic applies. In the short run, a fall in the money supply leads to a fall in aggregate output as the economy moves down the short-run aggregate supply curve. In the long run, however, the monetary contraction reduces only the aggregate price level, and aggregate output returns to potential output. Monetary Neutrality How much does a change in the money supply change the aggregate price level in the long run? A change in the money supply leads to a proportional change in the aggregate price level in the long run. For example, if the money supply falls 25%, the aggregate price level falls 25% in the long run; if the money supply rises 50%, the aggregate price level rises 50% in the long run; and so on. AD1 Y2 . . . but the eventual rise in all prices leads to a fall in sh...
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This note was uploaded on 09/09/2009 for the course ECON 701 taught by Professor Charlie during the Spring '09 term at École Normale Supérieure.

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