Question

Using the AD-AS graph and the IS-LM graph, illustrate and explain the short-run and medium-run effects of an increase in the money supply. Discuss what happens to the price level, output, and the interest rate in the short-run and in the medium-run.

Answer 1

Short-run effect of expansionary monetary policy:

When the Fed increases the money supply, the LM curve shifts to the right, as people need to have a higher income to restore equilibrium in the financial market. The IS curve doesn't change and this results in a lowering of the interest rate. This increases investment, and therefore output.

For any level of prices, the output is higher.

The net effect in the short run is still to have LM shifts to the right, and AD shifts to the right.

Thus, in the short-run, this implies that the whole AD curve shifts to the right. Output increases.

With the AD curve shifting to the right, unemployment reduces, and wages increase. It shall be noted that when the AD curve shifts to the right, the equilibrium price level increases, leading to a decrease in the real supply of money. Firms respond by setting higher prices in order to maintain a constant mark-up. This increase in prices will lead to a shift in the LM curve: the contraction of the real money supply due to increased prices will push interest rates up and partially reduce output.

The effect in the medium run:

After the initial increase of money supply, expectations about prices gradually adjust until eventually, the economy comes back to the natural level of output.

After the initial increase in the money supply, prices have gone up while expectations were not updated. At the beginning of the next period, workers set their expectations for the prices in the coming period at Pe (1)=P(0). This shifts the AD curve to the left from AD0 to AD1. When workers anticipate a higher price level, they will want to get higher wages (for a given level of output), which will force firms to increase prices in order to maintain their mark-up. Those higher prices shrink the real money supply, which increases interest rates and depresses investment. Prices have gone up, and output has gone down, following this updating of price expectations. In the next stage, workers once again realize they have been mistaken by prices (which have gone up more than they expected).

They update their expectations about prices which increases nominal wages, increases prices, forces interest rates up, depresses investment, and therefore output. These cycles (increase in prices, reduction in output, updating of expectations) go on until equality is restored between actual and expected prices. It takes some time for this to happen. But once actual and expected prices are equalized, the output is back to its natural level.

Thus, Over the medium run, prices adjust, and real variables return to their original level. Over the medium run, Ms/P is constant. That means, money is neutral in the medium-run. Thus, the monetary policy can only have a short-run impact on the real economy.