Monetary Effects in the Long Run
Many economists believe that changes in the supply of money in the long run mainly affect the price level with little or no impact upon real output. We can understand this policy by analyzing the effects of. monetary changes in economies with different conditions of aggregate supply. As shown in Figure 26-8, monetary changes will affect aggregate demand ‘and will tend to change real GDP in the short run when there are unemployed resources and the AS curve is relatively flat. In our analysis of aggregate supply in the following chapters, we will see that the AS curve tends to be vertical or near-vertical in the long and prices adjust. Because of the price-wage adjustments and near-vertical AS curve, the output effects of AD shifts will diminish, and the price effects will tend to dominate in the long run. This means that as prices and wages become more flexible in the long run, to have a Lar in impact prices and a smaller impact on output.
If all adjustments eventually come in prices. all nominal variables are increased by 10 percent while all real variables are unchanged. In other words, nominal variables like the GDP deflator, the CPI, nominal GDP, wages, the money supply, dollar consumption, dollar imports, the dollar value of wealth, and so forth, are 10 percent higher, But real GDP. real consumption, real wages, real incomes, and the real value of wealth are all unchanged by the monetary), policy. In such a case, then, we say that neutral; meaning that changes in the money have no effect on real variables.
A word of caution is in order: The scenario that money changes lead ‘to proportionate changes in all nominal variables but no changes in real variables is intuitively plausible and supported by certain evidence. But it is not a universal law. The long run may be a period .of many decades; intervening events may throw the economy off the idealized long-run trajectory;’ and interest-rate changes along the path might have irreversible impacts upon the economy because of bankruptcies, trade changes, and other impacts.
The long-run neutrality of money is therefore only a tendency and not a universal law. This discussion of monetary policy has taken place without reference to fiscal policy. In reality, whatever, the philosophical predilections of the government, every advanced economy simultaneously conducts both fiscal and monetary policies. Each policy has strengths and weaknesses. In the chapters that follow, we return to an integrated consideration of the roles of monetary and fiscal policies both in combating the business cycle and in promotmg economic growth
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