Page 358 - Krugmans Economics for AP Text Book_Neat

Short-Run and Long -Run Effects of an Increase
in the Money Supply

To analyze the long - run effects of monetary policy, it’s helpful to think of the central
bank as choosing a target for the money supply rather than for the interest rate. In as-
sessing the effects of an increase in the money supply, we return to the analysis of the
long -run effects of an increase in aggregate demand.
Figure 32.1 shows the short -run and long -run effects of an increase in the money
supply when the economy begins at potential output, Y 1 . The initial short -run aggregate
supply curve is SRAS 1 , the long -run aggregate supply curve is LRAS, and the initial ag-
gregate demand curve is AD 1 . The economy’s initial equilibrium is at E 1 , a point of both
short - run and long - run macroeconomic equilibrium because it is on both the short -run
and the long - run aggregate supply curves. Real GDP is at potential output, Y 1 .
Now suppose there is an increase in the money supply. Other things equal, an in-
crease in the money supply reduces the interest rate, which increases investment spend-
ing, which leads to a further rise in consumer spending, and so on. So an increase in the
money supply increases the quantity of goods and services demanded, shifting the AD
curve rightward to AD 2 . In the short run, the economy moves to a new short - run
macroeconomic equilibrium at E 2 . The price level rises from P 1 to P 2 , and real GDP
rises from Y 1 to Y 2 . That is, both the aggregate price level and aggregate output increase
in the short run.
But the aggregate output level Y 2 is above potential output. As a result, nominal
wages will rise over time, causing the short - run aggregate supply curve to shift left-
ward. This process stops only when the SRAS curve ends up at SRAS 2 and the economy
ends up at point E 3 , a point of both short - run and long - run macroeconomic equilib-
rium. The long -run effect of an increase in the money supply, then, is that the aggre-
gate price level has increased from P 1 to P 3 , but aggregate output is back at potential

figure 32.1

The Short -Run and Long -Run Aggregate
price
Effects of an Increase in the An increase in the
level money supply reduces
Money Supply the interest rate and
An increase in the money supply generates increases aggregate LRAS
a positive short -run effect, but no long -run demand . . .
effect, on real GDP. Here, the economy be-
SRAS
gins at E 1 , a point of short - run and long - run 2
macroeconomic equilibrium. An increase in
SRAS 1
the money supply shifts the AD curve right-
ward, and the economy moves to a new
E 3
short -run equilibrium at E 2 and a new real
P 3
GDP of Y 2 . But E 2 is not a long - run equilib-
. . . but the eventual
rium: Y 2 exceeds potential output, Y 1 , lead-
rise in nominal wages
ing over time to an increase in nominal P 2 E 2
leads to a fall in
wages. In the long run, the increase in nom-
P 1 short-run aggregate
inal wages shifts the short - run aggregate AD 2 supply and aggregate
E 1
supply curve leftward, to a new position at output falls back to
SRAS 2 . The economy reaches a new short - potential output.
AD 1
run and long - run macroeconomic equilib-
rium at E 3 on the LRAS curve, and output Y 1 Y 2 Real GDP
falls back to potential output, Y 1 . The only
long - run effect of an increase in the money Potential
supply is an increase in the aggregate price output
level from P 1 to P 3 .
316 section 6 Inflation, Unemployment, and Stabilization Policies