Question

Present an analysis graph where you examine the long term impact of an increase in the money supply. Use your analysis to explain why increases in the money supply may explain the observed changes in both product prices and nominal wage levels over time. Also, uses your analysis to explain (using words) what it means when macroeconomists say “money is neutral.”

Answer 1

An increase in money supply decreases interest rate. Lower interest rate boosts investment, which increases aggregate demand, shifting AD curve rightward. This increases both price level and real GDP in short run, generating short-run inflationary gap.

In the long run, increase in price level will increase prices of inputs, increasing production costs. Firms will decrease output, lowering aggregate supply. SRAS shifts leftward, intersecting new AD curve at further higher price level and real GDP being restored to the potential GDP.

Since a short run increase in money supply only increases price level, which is a nominal variable, but doesn't change real GDP or unemployment, which are real variables, it is said that in long run, money is neutral.

In following graph, AD0, LRAS0 and SRAS0 are initial aggregate demand, long-run aggregate supply and short-run aggregate supply curves intersecting at point A with initial price level P0 and real GDP (potential GDP) Y0. When government spending increases, AD0 shifts right to AD1, intersecting SRAS0 at point B with higher price level P1 and higher real GDP Y1. Short run inflationary gap is (Y1 - Y0).

In long run, SRAS0 shifts left to SRAS1, intersecting AD1 at point C with further higher price level P2 and restoring real GDP to potential GDP level Y0.