1. MONEY, OUTPUT, ANDPRICES IN THE LONG RUN MODULE 32

2. MONEY, OUTPUT, AND PRICESMonetary policy is generally the policy tool of choice to stabilize the economy.In the long-run, changes in the quantity of money affect the aggregate price level, but they do not change real aggregate output or the interest rate.

3. SHORT-RUN AND LONG-RUN EFFECTSOF CHANGES IN THE MONEY SUPPLYTo analyze the long-run effects of monetary policy, it is helpful to think of the central bank as choosing a target for the money supply rather than for the interest rate.To assess the effects of changes in the money supply, we can analyze the long run effects of changes in AD.

4. SHORT-RUN AND LONG-RUN EFFECTS OF AN INCREASE IN THE MONEY SUPPLYAn increase in the money supply reduces the interest rate, which increases investment spending, which leads to a further rise in consumer spending, and so on.An increase in the money supply increases the quantity of goods and services demanded, shifting AD to the right.

5. SHORT-RUN AND LONG-RUN EFFECTS OF AN INCREASE IN THE MONEY SUPPLYIn the short run, the economy moves to a new short run equilibrium, with both the aggregate price level and aggregate output increasing in the short run.However, the aggregate output level is above potential output.

6. SHORT-RUN AND LONG-RUN EFFECTS OF AN INCREASE IN THE MONEY SUPPLYAs a result, nominal wages will rise over time, causing the SRAS curve to shift leftward.This process stops when the economy ends up at a point of both short-run and long-run equilibrium.

7. SHORT-RUN AND LONG-RUN EFFECTS OF AN INCREASE IN THE MONEY SUPPLYThe aggregate price level increases, but aggregate output is back at potential output.So, in the long run, a monetary expansion raises the aggregate price level, but has no effect on real GDP.

8. SHORT-RUN AND LONG-RUN EFFECTS OF AN INCREASE IN THE MONEY SUPPLY

9. SHORT-RUN AND LONG-RUN EFFECTS OF A DECREASE IN THE MONEY SUPPLYA decrease in the money supply raises the interest rate, which decreases investment spending, which leads to a further decrease in consumer spending, and so on.A decrease in the money supply decreases the quantity of goods and services demanded at any aggregate price level, shifting the AD curve to the left.

10. SHORT-RUN AND LONG-RUN EFFECTS OF A DECREASE IN THE MONEY SUPPLYIn the short run, the economy moves to a new short-run macroeconomic equilibrium at a level of real GDP below potential output and a lower aggregate price level.Both the aggregate price level and aggregate output decrease in the short run.

11. SHORT-RUN AND LONG-RUN EFFECTS OF A DECREASE IN THE MONEY SUPPLYOver time, when the aggregate output is below potential output, nominal wages fall.When this happens, the SRAS curve shifts rightward.This process stops when the economy is at a point of both short- run and long-run macroeconomic equilibrium.

12. SHORT-RUN AND LONG-RUN EFFECTS OF A DECREASE IN THE MONEY SUPPLYThe long-run effect of a decrease in the money supply is that the aggregate price level decreases, but aggregate output returns to potential output.In the long run, a monetary contraction decreases the price level, but has no effect on real GDP.

13. SHORT-RUN AND LONG-RUN EFFECTS OF A DECREASE IN THE MONEY SUPPLY

14. MONEY NEUTRALITYA change in the money supply leads to a proportional change in the aggregate price level in the long run.If the money supply falls by 25%, the aggregate price level falls 25% in the long run; if the money supply rises by 50%, the aggregate price level rises 50% in the long run.

15. MONEY NEUTRALITYIf all the prices in an economy (prices of final goods and services, and factor prices such as nominal wages) double. At the same time, suppose the money supply doubles.This would not make any difference to the economy, as all real variables are unchanged.

16. MONEY NEUTRALITYThis is explained by: if the economy starts out in long-run macroeconomic equilibrium, and the money supply changes, in order to restore long-run macroeconomic equilibrium, all real values must be restored to their original values, which includes restoring the real value of the money supply to its original level.

17. MONEY NEUTRALITYThis concept is known as money neutrality: money is neutral in the long run.changes in the money supply have no real effects on the economy in the long run.The only effect of a change in the money supply is to change the aggregate price level in the same direction by an equal percentage.

18. MONEY NEUTRALITYHowever, in the long run, we are all dead, so monetary policy does have powerful real effects on the economy in the short run, often making the difference between a recession and an expansion, which matters for societys welfare.

19. CHANGES IN THE MONEY SUPPLY AND THE INTEREST RATE IN THE LONG RUNIn the short run, an increase in the money supply leads to a fall in the interest rate; a decrease in the money supply leads to a rise in the interest rate.In the long run, however, changes in the money supply dont affect the interest rate at all.

20. CHANGES IN THE MONEY SUPPLY AND THE INTEREST RATE IN THE LONG RUNWhen the Fed increases the money supply, the interest rate falls in the short run.Over time, however, the aggregate price level rises, and this raises money demand, shifting the money demand curve rightward.The economy moves to a new long-run equilibrium and the interest rate rises to its original level.

21. CHANGES IN THE MONEY SUPPLY AND THE INTEREST RATE IN THE LONG RUNThe long-run equilibrium interest rate is the original interest rate because the eventual increase in money demand is proportional to the increase in money supply, counteracting the initial downward effect on interest rates.Changes in the money supply do not affect the interest rate in the long run.

22. CHANGES IN THE MONEY SUPPLY AND THE INTEREST RATE IN THE LONG RUNWith money neutrality, an increase in the money supply is matched by a proportional increase in the price level in the long run.The change in the aggregate price level then cause proportional changes in the demand for money.

23. CHANGES IN THE MONEY SUPPLY AND THE INTEREST RATE IN THE LONG RUNExample:1. A 50% increase in the money supply will raise the aggregate price level by 50%2. This increase the quantity of money demanded at any interest rate by 50%.3. The quantity of money demanded rises by as much as the money supply, and the interest rate returns back to its original level.