1. MONEY, OUTPUT, AND
PRICES IN THE LONG
RUN
MODULE 32

2. MONEY, OUTPUT, AND PRICES
Monetary 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 EFFECTS
OF CHANGES IN THE MONEY SUPPLY
To 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
SUPPLY
An 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
SUPPLY
In 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
SUPPLY
As 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
SUPPLY
The 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
SUPPLY
A 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
SUPPLY
In 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
SUPPLY
Over 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
SUPPLY
The 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 NEUTRALITY
A 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 NEUTRALITY
If 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 NEUTRALITY
This 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 NEUTRALITY
This 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 NEUTRALITY
However, “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 society’s welfare.

19. CHANGES IN THE MONEY SUPPLY AND
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; 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 at all.

20. CHANGES IN THE MONEY SUPPLY AND
THE INTEREST RATE IN THE LONG
RUN
When 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
RUN
The 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
RUN
With 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
RUN
Example:
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.