Question

Using an AD- AS model and the classical business cycles framework, show graphically and explain the effects of an unanticipated increase in the money supply (unanticipated expansionary monetary policy).

Answer 1

According to the classical business cycle frame work the business cycle fluctuations in the economy is due to the real shocks to the economy rather than the nominal shocks. The examples of the production functions are, shocks to the production function, the size of the labour force, the quantity of government purchases and the spending and the saving decisions by the individuals in the country.

The unanticpated monetary policy has real effects in the short run but has no effect in the long run, this is shown by the following diagram.

In the intial stage the economy is at the point A, as the unanticipated policy occcurs the money supply in the economy increases this means more money in the hands of people so there will be an increase in the aggregate demand in the economy. So the aggregate demand in the economy arises and the output of the economy increases and also the price level in the economy. The economy moves point A to point B. So in the short run the unanticipatory money exapansionary policy is effective. But in the long run people will recogonize the true price level so the employees demand a higher wages. More wages to the employees increases the input costs of the firm and it force the firms to cut down their production. So in the long run the supply curve will shift to the left and the ouput remains at the original level. So there is only an increase in the price level in the economy.

So the nominal variables have not able to influence the economy in the long run, only the real shocks are able to do it