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loanable funds that arise at potential output. In the long run, then, changes in the money supply do not affect the interest rate.
So what determines the interest rate in the long run—that is, what determines r1 in
Figure 14-14? The answer is the supply and demand for loanable funds. More specifically, in the long run the equilibrium interest rate matches the supply and demand
for loanable funds in the loanable funds market that arise at potential output. economics in action
International Evidence of Monetary Neutrality
These days monetary policy is quite similar among wealthy countries. Each major nation (or, in the case of the euro, group of nations) has a central bank that is insulated
from political pressure; all of these central banks try to keep the aggregate price level
roughly stable, which usually means inflation of at most 2% or 3% per year.
But if we look at a longer period and a wider group of countries, we see large differences in the growth of the money supply. Between 1970 and the present the money
supply rose only a few percent per year in some countries, such as Switzerland and the
United States, but rose much more rapidly in some poorer countries, such as Bolivia.
These differences allow us to see whether it is really true that increases in the money
supply lead, in the long run, to equal percentage rises in the aggregate price level.
Figure 14-15 on page 364 shows the annual percentage increases in the money
supply and in the aggregate price level for a sample of countries over the period 364 PA R T 5 Figure S H O R T- R U N E C O N O M I C F L U C T U AT I O N S UNCORRECTED Preliminary Edition 14-15
60% The Long-Run Relationship
Between Money and Inflation
The horizontal axis shows the annual percent
increase in a country’s quantity of money
between 1970 and 2000. The vertical axis
shows the annual percent increase in a
country’s aggregate price level over the
same period. Each point represents a specific
country. The scatter of points lies close to a
45-degree line, demonstrating that in the
long run increases in the quantity of money
lead to roughly equal percent increases in
the aggregate price level. Bolivia 45-degree line 50
United States 20
0 10 20 30
Money supply growth rate, 1970–2000 Source: United Nations Statistical Database. ®®
® ® QUICK REVIEW According to monetary neutrality,
changes in the money supply do not
affect real GDP or the interest rate,
only the aggregate price level. Economists believe that money is neutral
in the long run.
In the long run, the equilibrium interest rate in the economy is determined in the loanable funds market.
It is the interest rate that matches
the supply and demand for loanable
funds that arise when the economy
is at potential output. 1970–2000, with each point representing a country. If the relationship between increases in the quantity of money and changes in the aggregate price level were exact,
the points would lie precisely on a 45-degree line. In fact, the relationship i...
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