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Principles of Economics- Mankiw (5th) 682

Principles of Economics- Mankiw (5th) 682 - 706 PA R T T W...

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706 PART TWELVE SHORT-RUN ECONOMIC FLUCTUATIONS and 26 were able to examine the determinants of real variables (real GDP, the real interest rate, and unemployment) without introducing nominal variables (the money supply and the price level). Do these assumptions of classical macroeconomic theory apply to the world in which we live? The answer to this question is of central importance to under- standing how the economy works: Most economists believe that classical theory de- scribes the world in the long run but not in the short run. Beyond a period of several years, changes in the money supply affect prices and other nominal variables but do not affect real GDP, unemployment, or other real variables. When studying year-to-year changes in the economy, however, the assumption of monetary neu- trality is no longer appropriate. Most economists believe that, in the short run, real and nominal variables are highly intertwined. In particular, changes in the money supply can temporarily push output away from its long-run trend. To understand the economy in the short run, therefore, we need a new model.
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