Question

13. “A perfect-foresight model predicts that expansionary monetary policy has no effect on the level of output.” Comment on this statement with the help of an AD-AS diagram.

Answer 1

Answer)

Under Classical Assumption, Monetary Expansion will fail to increase output level. This is because AS is vertical at full employment level of output. With monetary expansion, AD shifts up exactly in the same proportion of increase in nominal money supply. As a result, there is excess demand for goods at initial price level. Consequently, firms try to produce more of output by employing more workers. But, with full employment, it results into increase in wage rate and thereby, increase in cost and price level.

In the terms of IS - LM Framework, increase in nominal money supply shifts the LM curve to the right. As a result, output exceeds full employment level and consequently, price level increases. Increase in price level reduces the real money supply and therefore, LM curve shifts leftward. Since, output remains same, so it implies that increase in price must be in the same proportion of increase in nominal money supply. That is why, it is said that money is neutral which means it has no effect on real variables (monetary neutrality or classical dichotomy).

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