The Effects of a Monetary Expansion

Question: What are the short-run and medium-run effects of

an unexpected increase in AD attributable to an unexpected monetary
expansion?
Dynamics of Adjustment
Assumption: Initially (before the change in nominal money),
1 = = : = = at .
In other words, the economy is initially in the long-run equilibrium or
in a general equilibrium at A, where = = .
Recall: 7.9 =

, ,

Dynamic Adjustment from the SR to the Medium Run

The central bank unexpectedly and without any publicity increase
the money supply M

For a given , leads to

(The curve shifts down from to : One is due to the
increase in . The other is due to the increase in even in the short
run. This increase in shifts the curve from to ,
partially offsetting the effect of the increase in . curve shifts
down initially to if the price level did not change)
shifts to the right from 1 to 2
to 2 and to 2 in the short run

Dynamic Adjustment from the SR to the Medium Run

Because wage setters didnt expect this increase in the price level
and the AS curve remains unchanged, the expected price level
remains at = and in the short run, > and > at .
Thus, the unexpected expansion in AD causes the economy to boom.
Over time, wage setters revise their expectations upward:
shifts upward over time to 2
The economy moves upward along the

(Since > , continues to increase.

The curve

shifts up The economy moves up along the curve)

In the medium run or in the long run,
2 = 2 = at : 3 = and 3 = 3 .

Dynamic Adjustment from the SR to the Medium Run

The economy returns to the natural level of output in the medium run
or in the long run, but at a much higher price level.
(In the medium run or in the long run, the curve eventually
returns to where it was before the increase in . The interest rate is
back to its initial value, )
Note that if output is back to the natural level of output ,
the real money stock

must also be back to its initial level; i.e.,

the proportional increase in prices must be equal to the same

proportional increase in the nominal money stock.

Dynamic Adjustment from the SR to the Medium Run

is unchanged with G and T being unchanged

must also remain unchanged: M and P each increase in

the same proportion.

Figure 7.13: Dynamic Effects of a Monetary Expansion on

Output and Interest Rate

Dynamic Adjustment from the SR to the Medium Run

This analysis demonstrates an important principle:

(i) Short-run monetary non-neutrality (from A to B): in the short run,
the increase in the money supply leads to a rise in output, money isnt
neutral in this sense, since producer mistakes the higher nominal price of
their output for an increase in its relative price, rather than an increase in
the overall price level, ending up producing more than they would have.
(ii) Long-run monetary neutrality (from A to C): an unanticipated
increase in the money supply is neutral in the long run since people
obtain information about the true price level and adjust their expectations

accordingly.

Monetary Neutrality or Neutrality of Money

In the short run, a monetary expansion leads to , , and
Question: How much of the effect of a monetary expansion falls
initially on output and how much on the price level?
Answer: It depends on the slope of the AS curve.

In the medium run or in the long run, the increase in nominal money is
reflected in a proportional increase in the price level. The increase in
nominal money has no effect on output or on the interest rate;
that is, over time, the price level increases, and the effects of the
monetary expansion on output and on the interest rate disappears.

Neutrality of Money
We need to explain how monetary policy is related to other
macroeconomic variables, such as prices, interest rates, output, and
employment.
The theory we want to develop is called the quantity theory of
money, which explains how money affects the economy in
the medium run or in the long run.
7.10 : =

nominal GDP

For example, = $5,200, = 2 = $10,400; a money

supply of $5,200 billion turning over 2 times a year would support
a nominal GDP of $10,400 billion.

Neutrality of Money: Quantity Theory of Money

Assumption: (i) is constant.
(ii) The factors of production and the production function have
already determined output .
7.11 : = % + % = % + %
+ = + (%) = (%).

Meaning: According to the quantity theory of money, the price level

is proportional to the money supply.

Neutrality of Money
Neutrality of money in the medium run or in the long run
The absence of a medium-run or a long-run effect of money on
output and on the interest rate
A change in the nominal money supply changes the price level
proportionately but has no effect on real variables such as output,
employment, the relative prices, or the real interest rate
The practical relevance of monetary neutrality is much debated by
classical economists and Keynesians.
The basic issue is the speed of price adjustment.

Neutrality of Money: Classic vs. Keynesian

Classical economists believe that the economy possesses powerful
self-correcting forces that guarantee the natural rate of employment
(= full employment) and prevent the output from falling below
the natural level of output for more than a short run. These
forces consist of flexible wages and prices, which could adjust rapidly
to absorb the impact of shifts in aggregate demand : In the
classical view, a monetary expansion is rapidly transmitted into prices
and has, at most, a transitory effect on real variables the economy
moves quickly back to the natural level of output. So, they see no
need for the government to engage in stabilization policy.

Neutrality of Money: Classic vs. Keynesian

Keynesians agree that money is neutral after prices fully adjust
but believe that, because of slow price adjustment, the economy may
be for long in disequilibrium. During this period the increased money
supply causes output and employment to rise and the real interest
rate to fall.

Warning on Neutrality of Money

The neutrality of money in the medium run does not mean that
monetary policy cannot or should not be used to affect output.
An expansionary monetary policy can help the economy move out of
a recession and return more quickly to the natural level of output.
It is a warning that monetary policy cannot sustain higher output
forever.

A Decrease in Budget Deficit

Suppose that the government is running a budget deficit and decides
to reduce it by decreasing its spending from to while leaving
taxes unchanged.
Question: How will this affect the economy in the short run and in the
medium run?

Assumption: = at point initially

=
The economy is initially in the long-run or general equilibrium

Dynamic Adjustment from the SR to the Medium Run

falls to : < 0
curve shifts to the left from to
(The curve shifts the left to . If didnt change, the economy
would move from to B)
In the short run, falls to and falls to

(Since in response to , and the curve shifts down to

, a partially offsetting shift of the curve)
In the short run, the economy moves from to
(The initial effect of the deficit reduction triggers lower output a recession and the lower interest rate. is uncertain in the short
run.)

Dynamic Adjustment from the SR to the Medium Run

Over time, since < the curve keeps shifting down
(As long as < , continue to decline, leading to

. The

curve continues to shift down.)

The economy moves down along the until =
(The economy moves down along until = )
At , = : The recession is over.
(At , the interest rate is lower than it was before the deficit
reduction, down from to )

Figure 7.14: Dynamic Effects of a Decrease in the Budget Deficit

on the Output and the Interest Rate

Change in Money vs. Change in Deficit

is back to the natural level of output , but are lower

than before the shift since we are assuming that is constant, not
growing, and there is no sustained inflation.

The composition of output is also different.

New relation at : = + , +
stays the same because income and taxes are unchanged.
is lower than before.
must be higher than before the deficit reduction higher by an amount
exactly equal to the decrease in . Put another way, in the medium run,
a fall in the budget deficit unambiguously leads to a decrease in
the interest rate and an increase in investment.

Summary: Decrease in the Budget Deficit

In the short run, without an accompanying change in
monetary policy and uncertain .
In the medium run, = , , and .
In the long run, if a lower government budget deficit leads to more
investment, it will lead to a higher capital stock, and the higher
capital stock will lead to higher output.

Different Opinions about Budget Deficit Reduction

Disagreement among economists about the effects of measures
aimed at increasing saving (a fall in the budget deficit) often comes
from differences in time frame.
Those who are concerned with short-run effects worry that
measures to increase saving might create a recession and decrease
saving and investment for some time.
Those who look beyond the short run see the eventual increase in
saving and investment and emphasize the favorable medium-run and
long-run effects on output.

Increase in the Price of Oil

Increase in the Price of Oil

Two Incidents in an Increase in the Price of Oil:
Changes in supply: The formation of OPEC and disruptions of oil
supply due to wars and revolutions in the Middle East in the 1970s
Changes in demand: Fast growth of emerging economies in
the 2000s
The implication for U.S. firms and consumers was the same:
more expensive oils, more expensive energy.

Changes in the Price of Oil

A drawback in using our current model: The price of oil appears
neither in the AD relation nor in AS relation since, until now, we have
assumed that labor was only an input to the production.
Solution: One way to extend our current model using only labor
would be to recognize explicitly that output is produced using labor
and other inputs (including energy).

Changes in the Price of Oil

Q: What effect an increase in the price of oil has on the price set by
firms and on the relation between output and employment?
A: An easier way is to capture the increase in the price of oil by an
increase in - the markup of the price over the nominal wage :
given wage, an increase in the price of oil increases the cost of
production, forcing firms to increase prices.
Track the dynamic effects of an increase in the markup on output and
the price level by working backward in time.

Effects of an Increase in the Price of Oil

Question: What happen to the natural rate of unemployment
when the (real) price of oil increases?
Initial equilibrium at and

to
(The higher the markup, the lower the real wage implied by )
The equilibrium moves from to
The real wage

is lower

The natural rate of unemployment is higher: Getting workers to

accept the lower real wage requires an increase in unemployment

Effects of an Increase in the Price of Oil

The increase in the natural rate of unemployment leads to
a decrease in the natural level of output , assuming that each
unit of output still requires one worker in addition to the energy input
and that the increase in the price of oil is permanent.

Figure 7.15: Effects of an Increase in the Price of Oil on the

Natural Rate of Unemployment

Dynamic Adjustment to an Increase in the Price of Oil

Before the increase in the price of oil, = at with
= and = ; ie, the economy is initially in the long-run or
general equilibrium.

In the short run (given ), relation: = 1 + 1

Effect of an increase in the price of oil is captured by
at any level of
curve shifts upward
The economy moves along the curve
to and to

Dynamic Adjustment to an Increase in the Price of Oil

Recall that the curve always goes through the point such that
= and = .
After the increase in the price of oil, the new curve goes through
point B.
In the short run, the increase in the price of oil leads firms to increase
their prices, leading to the decrease in output and demand.
In the medium run, > and > at
curve continue to shift up
The economy moves over time along the curve from to
At , = and is higher than before the oil shock

Dynamic Adjustment to an Increase in the Price of Oil

Summary: Increase in the price of oil decreases output and increases
prices in the short run.
If the increase in the price of oil is permanent, then output is lower
both in the short run and in the medium run.

Figure 7.16: Dynamic Effects of an Increase in the Price of Oil

Two Incidents of an Increase in the Price of Oil

Two Incidents of an Increase in the Price of Oil

The increase in the price of oil in the 1970s was followed by major
increases in inflation and in unemployment. This fits out summary
very well.
The increase in the price of oil in the 2000s was associated with
neither an increase in inflation nor an increase in unemployment.

Final Words
We think about output fluctuation (sometimes called business cycle)
movements in output around its trend (potential GDP ) in this
chapter.
Each shock has dynamic effects on output and its components.
These dynamic effects are called the propagation mechanism of the
shock. Propagation mechanisms are different for different shocks.