Question

Question 1:

(a) What do we mean when we say money is neutral?

(b) Bill Clinton believed in working with the Fed to use Monetary Policy to help the economy grow while he was President in the early 1990s. That is, he believed that money had real effects (on output and the interest rate). Show that Bill Clinton was right, and money is non-neutral in the short run. (Guide: Draw the IS-LM graph only).

(c) Ronald Reagan believed that Monetary Policy should not be used to impact the economy, because a change in Monetary Policy only leads to a change in the price level. Show that Ronald Reagan was right ,and money is neutral in the medium run. (Guide: Draw the AS-AD graph only)

(d) How can both of these men be right even though they disagree about the neutrality of money?

Answer 1

a) When we say money is neutral we actually refer to the Classical Dichotomy. This basically means that any change in the money supply will cause an equi-proportional change in the price level so that real money balance (=money supply/price level) is unchanged. This means that GDP will stay unchanged. Thus all real variables like GDP are unaffected while the Nominal Variables like Price rise in same proportion.

b) In the short-run monetary policy is effective because prices take time to change. Thus, in short run prices are fixed and hence real money supply rises. This shifts the LM curve which shows money market equilibrium, to the right raising output and reducing the rate of interest.

The diagram above shows the case where equilibrium changes from E^/ to E^// and Output rises from Y^/ to Y^// while interest rate falls from i^/ to i^//.

c)In this figure, the money supply rise causes Aggregate Demand curve to shift from AD¹ to AD² causing output to rise in short run. However, in medium run the price level rises from P₁ to P₂  causing the short run Aggregate supply curve in future to be SRAS². This causes output to return to initial level when the new medium run equilibrium is at point H. Thus monetary policy is ineffective in medium run when prices are free to adjust fully.

d) The basic difference is that neutrality of money holds in the medium run when prices are free to adjust in response to demand. But in short run when prices are held fixed then the monetary policy is effective.This is the basic difference between the two which led them to make such policies because one was concerned with short run impact while the other was concerned with medium run.