Uncorrected preliminary edition how do we know this

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Unformatted text preview: ort-run aggregate AD2 supply back to potential output. Real GDP 362 PA R T 5 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 There is monetary neutrality when changes in the money supply have no real effects on the economy. UNCORRECTED Preliminary Edition How do we know this? Consider the following thought experiment: Suppose all prices in the economy—prices of final goods and services and also factor prices, such as the nominal wage rate—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—including the real value of the money supply—are unchanged, so there is no reason for anyone to behave any differently. We can state this argument in reverse: if the economy starts out in long-run macroeconomic equilibrium and the nominal money supply changes, restoring longrun macroeconomic equilibrium requires restoring all real values to their original values. This includes restoring the real money supply to its original level. So if the money supply falls 25%; the aggregate price level must fall 25%; if the money supply rises 50%, the price level must rise 50%; and so on. This analysis demonstrates the concept known as monetary neutrality, in which changes in the money supply have no real effects on the economy—no effects on real GDP or its components—and 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. This is, however, a good time to recall the dictum of John Maynard Keynes: “In the long run we are all dead.” In the long run, changes in the money supply don’t have any effect on real GDP, interest rates, or anything else except the price level. But it would be foolish to conclude from this that the Fed is irrelevant. Monetary policy does have powerful real effects on the economy in the short run, often making the difference between recession and expansion. And that matters a lot for society’s welfare. The Interest Rate in the Long Run In the short run an increase in the money supply leads to a fall in the interest rate, and a decrease in the money supply leads to a rise in the interest rate. In the long run, however, changes in the money supply don’t affect the interest rate. Figure 14-14 shows why. It is similar to Figure 14-11, but in this case panel (a) shows the real money demand curve, RMD. Panel (b), as in Figure 14-11, shows the supply and demand for loanable funds. We assume that the economy is initially in long-run macroeconomic equilibrium at potential output, E, in both panels, with the nominal money supply equal to M 1 and the price level equal to P1. The demand curve for loanable funds is D, and the initial supply curve for loanable funds is S1. The initial equilibrium interest rate is r1. Now suppose the nominal money supply rises from M 1 to M 2. We already know from the neutrality of money that in the long run the aggregate price le...
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