MODULE 32: MONEY, OUTPUT, AND PRICES IN THE

LONG RUN

The purpose of this module is to look at the impact of monetary policy in the long run.

Student learning objectives:

 The effect of an inappropriate monetary policy.

 The concept of monetary neutrality and its relationship to the long-term economic effects of monetary policy.

Key Economic Concepts For This Module:

 The concept of money neutrality asserts that expansionary monetary policy to boost the economy may increase AD and real GDP in the short run, but in the long run the economy will return to potential GDP with a higher price level.

 In the same sense, contractionary monetary policy to fight inflation may decrease AD and the price level in the short run, but in the long run the economy will return to potential GDP with a lower price level.

 In the long run, money neutrality predicts that interest rates in the money market will also return to long-run levels as money demand responds to either higher (expansionary) or lower (contractionary) price levels in the macroeconomy.

Common Student Difficulties:

 After learning about the short-run impact of monetary policy in the previous module, the notion of money neutrality is rather off-putting. After all, if monetary policy is believed to have no long-run impact on interest rates or real GDP, what is the point? Stress to the students that monetary policy in the short run can be effective at shortening the duration of a recession and that’s certainly a positive economic outcome.

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In-Class Presentation of Module and Sample Lecture

Suggested time: This module can be covered in one hour-long class session with additional time used for practice problems.

  1. Money, Output, and Prices
  1. Short-Run and Long-Run Effects of an Increase in the Money Supply
  2. Money Neutrality
  3. Changes in the Money Supply and the Interest Rate in the Long Run
  1. Money, Output, and Prices

The Federal Reserve can use its monetary policy tools to change the money supply and cause equilibrium interest rates in the money market to increase or decrease. But what if a central bank pursues a monetary policy that is not appropriate?

We will consider how a counter-productive action by a central bank can actually destabilize the economy in the short run.

We also introduce the long-run effects of monetary policy. As we learned in the last section, the money market (where monetary policy has its effect on the money supply) determines interest rates only in the short run. In the long run, interest rates are determined in the market for loanable funds. Here we look at long run adjustments and consider the long-run effects of monetary policy.

  1. Short-Run and Long-Run Effects of an Increase in the Money Supply

There are times when the central bank can engage in monetary policy that is actually counterproductive. In other words, the policy might move the economy away from potential GDP rather than closer to potential GDP.

Suppose the economy is currently in LR equilibrium.

 If the Fed were to conduct expansionary monetary policy, the interest rate would fall.

 A lower interest rate would shift AD to the right.

 In the short run, real GDP would increase, but so would the aggregate price level.

 Eventually nominal wages would rise in labor markets, shifting SRAS to the left.

 Long-run equilibrium would be established back at potential GDP and a higher price level.

 So in the long run, expansionary monetary policy doesn’t increase real GDP, it only causes inflation.

296Section 6: Inflation, Unemployment, and Stabilization Policies

Note: the instructor can tell the story of what happens if the Fed had conducted contractionary monetary policy. In the long run, real GDP will return to potential GDP but the price level will have decreased.

  1. Money Neutrality

Monetary neutrality: changes in the money supply have no real effects on the economy. In the long run, 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.

How does money neutrality work?

 Suppose all prices in the economy—prices of final goods and services and also factor prices, such as nominal wage rates—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—such as real GDP and the real value of the money supply (the amount of goods and services it can buy)—are unchanged.

 So there is no reason for anyone to behave any differently.

By the same intuition, we can say that if the money supply increases by any given percentage, in the long run, the aggregate price level will rise by the same percentage.

  1. Changes in the Money Supply and the Interest Rate in the Long Run

In the short run, we have seen that an increase in the MS causes short-term interest rates to fall. But what happens in the long run?

Suppose the money market is in equilibrium at an interest rate of i*%.

 Suppose MS increases by 10% to M’. The short-run interest rate falls.

 Money neutrality says that in the long run, the aggregate price level rises by 10%.

 When aggregate prices rise by 10%, households will increase their demand for money by 10%.

 When both MS and MD shift to the right by 10%, the long-run equilibrium interest rate returns to i*%.

Module 32: Money, Output, and Prices in the Long Run / 297

So in the long run, money neutrality insures that the interest rate won’t change after a change in the money supply.

In-Class Activities and Demonstrations

It will be a good use of time to practice at least one exercise that addresses the short-run and long-run impacts of monetary policy.

1. a. Draw a correctly labeled graph of aggregate demand and supply showing an economy in long-run equilibrium.

  1. Draw a correctly labeled graph of equilibrium in the money market.
  2. On your graph in part b), show what happens to the money market in the short run if the central bank decreases the money supply.
  3. On your graph in part a), show what happens to the macroeconomy in the short run if the central bank decreases the money supply.
  4. On both graphs, show what will happen in the long run. Explain these adjustments.

298Section 6: Inflation, Unemployment, and Stabilization Policies