This preview shows page 1. Sign up to view the full content.
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
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
level An increase in the
money supply reduces
the interest rate and
demand . . . LRAS
P2 E2 P1
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
View Full Document
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.
- Spring '09
- Monetary Policy