Question

Discuss the following statement.

Monetary policy can be inflationary without being expansionary.

Answer 1

Suppose the economy is in the long run equilibrium with output Y and price level P. Now, the Central Bank conducts a monetary expansion which leads to an increase in aggregate demand at each price level shifting AD from AD to AD’ which, at given aggregate supply, creates a condition of excess demand in the market pushing the prices upwards from P to P’ and output from Y to Y’. In long run, the workers in production units realise that their real wages have decreased due to  an increase in price level, so, they start demanding more wages, increasing cost of production of the firms leading to a decrease in short run aggregate supply shifting SRAS curve to the left from SRAS to SRAS’. This again creates a situation of excess demand in the market causing prices to rise further to P” but output decreases to Y, the long run equilibrium level. Thus, in long run a monetary expansion merely increased the price level and did not affect the level of output. Therefore, monetary policy can be inflationary without being expansionary.

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