Page 360 - Krugmans Economics for AP Text Book_Neat

figure 32.2

The Long -Run Determination of Interest
the Interest Rate rate, r MS 1 MS 2 An increase in the money
supply lowers the interest
In the short run, an increase in the money supply rate in the short run . . .

from M 1 to M 2 pushes the interest rate down from
r 1 to r 2 and the economy moves to E 2 , a short-run
equilibrium. In the long run, however, the aggregate
. . . but in the long run higher
price level rises in proportion to the increase in the
money supply, leading to an increase in money de- E 1 E prices lead to greater money
r 3 demand, raising the interest
mand at any given interest rate in proportion to the 1 rate to its original level.
increase in the aggregate price level, as shown by
the shift from MD 1 to MD 2 . The result is that the
quantity of money demanded at any given interest
E 2
rate rises by the same amount as the quantity of
r 2 MD 2
money supplied. The economy moves to long-run MD 1
equilibrium at E 3 and the interest rate returns to r 1 .
Quantity of money
M 1 M 2

Figure 32.2 shows the money supply curve and the money demand curve before and
after the Fed increases the money supply. We assume that the economy is initially at E 1 ,
in long - run macroeconomic equilibrium at potential output, and with money supply

M 1 . The initial equilibrium interest rate, determined by the intersection of the money
demand curve MD 1 and the money supply curve MS 1 , is r 1 .
fyi

International Evidence of Monetary Neutrality
These days monetary policy is quite similar countries during the period 1970–2007, with factors besides money affect the aggregate price
among wealthy countries. Each major nation (or, each point representing a country. If the relation- level. But the scatter of points clearly lies close to
in the case of the euro, the eurozone) has a cen- ship between increases in the money supply and a 45-degree line, showing a more or less propor-
tral bank that is insulated from political pressure. changes in the aggregate price level were exact, tional relationship between money and the aggre-
All of these central banks try to keep the aggre- the points would lie precisely on a 45-degree line. gate price level. That is, the data support the
gate price level roughly stable, which usually In fact, the relationship isn’t exact because other concept of monetary neutrality in the long run.
means inflation of at most 2% to 3% per year.
But if we look at a longer period and a wider Average
group of countries, we see large differences in the annual
increase in
growth of the money supply. Between 1970 and 45-degree
price level
the present, the money supply rose only a few 25% line
percentage points per year in countries such as Iceland
Switzerland and the United States, but rose much 20
Japan
more rapidly in some poorer countries, such as
Switzerland
South Africa. These differences allow us to see 15 South
Africa
whether it is really true that increases in the
money supply lead, in the long run, to equal per- 10 United Canada Europe
States
centage increases in the aggregate price level. Korea
The figure shows the annual percentage in- 5 India
Australia
creases in the money supply and average annual
increases in the aggregate price level—that is, 0 5 10 15 20 25 30%
the average rate of inflation—for a sample of Average annual increase in money supply

318 section 6 Inflation, Unemployment, and Stabilization Policies