1. Like expansionary monetary policy, expansionary fiscal policy returns output in
the medium run to its natural level, and increases prices. Therefore, fiscal policy is
A policy is neutral if it only affects nominal variables (prices, nominal wages,
nominal money supply) in the medium run, but does not affect real variables (output, the
components of output, interest rates, etc.). Although fiscal policy does not, in the medium
run, affect the natural level of output, it does alter the composition of output (an
expansionary fiscal policy will, for instance, decrease investment in the medium run). So
it does affect real variables, even though a cursory examination of the AS-AD diagram
might give the impression that it does not.
2. If investment is completely insensitive to the interest rate (i.e. in the Investment
function I = aY – bi, b is equal to zero), then the AD curve will be vertical.
The reason that the AD curve is usually downward sloping is that an increase in
prices reduces the real money supply, which increases interest rates, which in turn
reduces investment and therefore output. So if investment is insensitive to changes in the
interest rate, then one of the links in the above argument is broken, and changes in prices
no longer affect the output level. So the AD curve will be vertical.
3. A politician faced with a steeper AS curve is more likely to embark on a given
disinflation program than one faced with a flatter AS curve (assume that the steeper
slope is due to a higher sensitivity of nominal wages to the unemployment rate).
A steeper AS curve (resulting from a higher sensitivity of nominal wages to the
unemployment rate ) is equivalent to a steeper Phillips curve. The unemployment costs of
a disinflation program will be lower with a steeper Phillips curve than with a flatter
4. Money cannot be neutral in the short-run – the neutrality of money is exclusively
a medium run phenomenon.
If workers have rational expectations, then an increase in money will lead the
workers to at once revise their expected price to be equal to the new medium run
equilibrium price (assuming that workers can revise their expectations as soon as the
increase in money takes place). The economy will merely jump from one medium run
equilibrium to another, with none of the usual gradual shifts in the AS curve. If workers
can only adjust expectations after a lag, then the economy moves to a short run
equilibrium, where the new AD curve intersects the old AS curve, but thereafter it jumps
to the new medium run equilibrium with none of the usual gradual shifts in the AS curve.
Consequently, money will be neutral in both the short run and the medium run.