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short run, we can replace the nominal interest rate with the real interest rate: . Now we can express r as a function of Y and plot this expression in Diagram 2 with Y and r on the axes: . This liquidity-money (LM) curve represents all combinations of output and real interest rate that clear the money market. When the Fed increases the money supply and the price level is fixed in the short run, real interest rate decreases (Diagram 2). The LM curve shifts clockwise (Diagram 3). We assume that output is determined by demand in the short run. If firms are monopolistically competitive, i.e. there are many of them in each industry, but each product is slightly different from others, each firm optimally charges a price higher than its marginal cost. If the demand increases a little, each firm is still willing to supply this greater quantity because price is still above marginal cost. Therefore, the short run equilibrium is found at the intersection of the LM curve and the aggregate demand curve. In the short run, output is higher; real interest rate is lower; prices are fixed.
In the medium run, people demand more than firms are willing to sell at the lower interest rate. Prices start to go up (Diagram 2). The LM curve starts shifting back because people want to carry more nominal money when prices are rising (Diagram 3). In the medium run, output is declining; real interest rates are rising; prices are rising. In the long run, output and the real interest rate revert to the classical equilibrium at the intersection of aggregate supply and aggregate demand. Only prices are higher. c. The result in (b) is clearly different from the classical model. The key assumptions are the flexibility of prices in the classical model and price stickiness in the Keynesian model. When prices are flexible, everyone realizes that there is more money in the economy but the same amount of real goods. Hence, prices go up instantaneously, and there are no real changes. However, if prices are sticky in the short run, people can buy more for a while. Hence, real interest rates fall and real output increases. Money is neutral in the classical model and not neutral in the Keynesian model.
2. Lumiere
i. When the money supply decreases, the LM curve shifts counterclockwise (Diagram 4). Remember that the LM curve is given by . When M decreases, r increases for any value of Y. If output is supply-determined, both real interest rate and real output increase. In the medium run, output supplied is greater than output demanded at the higher interest rate. Prices start falling, and the LM curve starts shifting back. The initial equilibrium is reached in the long run.
ii. When money supply increases, the LM curve shifts clockwise. Both real interest rate and real output decrease. In the long run, they revert to the classical equilibrium, while the price level increases. iii. Changes in money supply affect real interest rate and real output; therefore, money is not neutral when prices are sticky and output is supply-determined. However, money affects output in the wrong direction. In this model, expansionary monetary policy decreases output, and contractionary policy increases output. This is clearly contradicted by empirical evidence. In reality, when the Fed increases the money supply (equivalently, when the Fed lowers the interest rate), real output usually increases for some time. When the Fed decreases the money supply (raises the interest rate), real output typically decreases.
3. Gaston
i. If output is determined by the short side of the market, then at any particular real interest rate, the minimum of aggregate supply and demand determine the actual output: Y = min{Y d, Y s} (solid lines in Diagram 5).
When money supply decreases, the LM curve shifts counterclockwise (Diagram 5). For r > r*, the short-run equilibrium is determined by the intersection of the LM curve and the aggregate demand curve. Real interest rate increases, and real output decreases in the short run. In the medium run, demand is less than supply; hence, prices go down. Real interest rate and real output return to the classical equilibrium; prices are lower in the long run. ii. When money supply increases, the LM curve shifts clockwise. For r < r*, the short-run equilibrium is determined by the intersection of the LM curve and the aggregate supply curve. Real interest rate decreases, and real output decreases as well in the short run. In the medium run, demand is greater than supply; hence, prices go up. Real interest rate and real output return to the classical equilibrium; prices are higher in the long run. iii. Money is still not neutral when prices are sticky and output is determined by the short side of the market. However, money affects output in the right direction only when money supply is decreased. In this model, both expansionary and contractionary policies decrease output. This is contradicted by empirical evidence because when the Fed increases the money supply (equivalently, when the Fed lowers the interest rate), real output usually increases for some time. To get consistent predictions in the Keynesian model, output must be demand-determined.