The Effects of a Monetary Expansion

The effects of a monetary expansion are described in Figure 7.2. Suppose the economy begins in medium-run equilibrium, with the expected price level equal to the actual price level, and output at its natural level. An increase in the money supply shifts LM down in the top panel of the figure (to LM'), and simultaneously shifts AD to the right in the bottom panel. At the original price level, the horizontal shift of the AD curve (point B in the figure) equals the change in output in the IS-LM diagram before considering the change in the price level.

The shift of the AD curve, however, tends to increase output, reduce the unemployment rate, and increase the nominal wage (through wage bargaining). The latter effect leads to an increase in the price level (through price setting). In other words, since the AS curve is upward-sloping, the new short-run equilibrium (point C) involves a higher price level. The increase in the price level shifts the LM curve up (to LM'') through its effect on M/P. This secondary shift of the LM curve offsets some of the initial shift of the LM curve. As a result, in the short run, the output increase from a monetary expansion is less in the AD-AS model than in the IS-LM model. The increase in the price level offsets some of the effect of the monetary expansion on the real money supply.

Figure 7.2: A Monetary Expansion in the AD-AS Model

At the new short-run equilibrium (point C), the price level has increased above its expected level. As a result, in the next period, the AS curve will shift along the segment CD. AS will continue to shift up until Y returns to its natural level at point D in the bottom panel. AS shifts up, and P increases, reducing M/P and shifting the LM curve up. At point D, P has increased sufficiently to restore M/P to its original value, which implies that the LM curve has returned to its original position.

The new medium-run equilibrium is exactly the same as the original one, except that the price level has risen in proportion to the increase in M. The composition of GDP is the same as in the original medium-run equilibrium. Since a monetary expansion does not affect any real variables in the medium run, monetary policy (or in short, money) is said to be neutral in the medium run.

Date: 2015-02-16; view: 892