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In: Economics

Why does increasing the money supply affect only nominal variables in the long run?

Why does increasing the money supply affect only nominal variables in the long run?

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Expert Solution

It is a characteristic of the money being neutral in the long run aka Money Neutrality.

We call the real variables as wealth, GDP, Income, Employment level and the nominal variables as prices, wages etc.

Increasing the money supply will not have any impact on the real variables in the long run because it is believed that there operates a self-correcting mechanism where prices are flexible and adjust automatically. Any increase in the money supply would not change the fundamental structure of the economy as it affects only nominal variables such W and P. Also, the Real wages are constant over the long run as both W and P changed by some proportion.

However, Money supply does have an impact on the real variables in the short run. This is also given by the Phillips curve. In short run, there exists a negative relation between unemployment and inflation. However, this relation disappears in the long run as the increased money supply does not impact the employment levels.

Assumption of Money Neutrality gives more reliable, predictive and stable parameters for the policymakers.

Rahul Sunny answered 1 year ago
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