Question

11.3 Illustrate an economy that is in LR equilibrium (which is labeled point A).   Indicate the short run effect of an increase in the money supply by labeling the new SR equilibrium as point B, and show the ensuing LR equilibrium from this increase in money supply and label it as point C using:
(a) an IS/LM/FE diagram.
(b) an AD/AS diagram.

Answer 1

The economy is shown at equilibrium in graph numbered a(i) for IS-LM-FE and b(i) for AD-AS framework.

In IS-LM-FE framework, increase in nominal money supply will shift the LM curve to the right in the short run. Hence we see that there is an increase in the output (shown in graph a(ii)).

But in the long run, what happens is that since the output exceeds full employment level and hence price level increases. Increase in price reduces the real money supply. Hence LM curve shifts leftward. Since output remains same, 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 in the long run (shown in graph a(iii)).

Similarly, in the AD-AS framework, in the short run, the SRAS (short run aggregate supply curve) remains horizontal so the price level does not change. Here the output increases and exceeds the full employment level (shown in graph b(ii)).

But in the long run, the prices adjust to clear all the markets, keeping the output stable. So the LRAS is actually a vertical line. Here the output remains fixed and hence money is rendered neutral in the long run here too (shown in graph b(iii)).