Notes 12: Monetary Neutrality
Suppose we start at Y*. What effect would an increase in the nominal money supply
(M) have on the economy in the long run?
Recall from Topic 5 in class, I introduced
Friedman’s Quantity Theory of Money, where M*V = P*Y. According to this theory,
changes in M will only have an effect on P in the long run.
Does our model yield a similar prediction?
This chapter will address this question. In order to explore how the change in the money
supply affects the economy in the long run, we will make the following assumptions:
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All consumers are non-liquidity constrained (non-Ricardian) PIH
NX = 0 (we will shut down the foreign sector)
Expected inflation has no effect on money demand (or, if you want, expected
inflation is equal to zero).
All other exogenous variables are held fixed.
Suppose the nominal money supply increases from M0 to M1. The increase in the
money supply will shift both the LM curve (recall from Note 9 that we represent the LM
curve as M/P) to the right and the AD curve (recall from Note 9 that AD represents all the
good and money in the demand side of the economy) to the right. Why?
An increase in the nominal money supply (M) will increase the real money supply
(increases the numerator of M/P) putting downward pressure on real interest rates as the
LM curve shifts to the right from LM (M0, P0) to LM (M1, P0) as a result of M/P
increasing. The lower interest rates will increase firm investment (I) which increases
output (Y). Let’s summarize the effects of this policy graphically (in steps) below:
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LRAS
LM (M0, P0)
LM(M1, P1)
r0
0
MAIN FIGURE 1
LM(M1,P0)
r1
1
a
IS
rz
z
Y0*
Y1
What has happened in the IS-LM market?
Suppose we start at point (0) corresponding to point Y*0 and r0. Holding P constant, an
increase in M will shift the LM curve shifts right (to LM(M1,P0)). We will discuss the
shift from LM(M1,P0) to LM(M1,P1) after we talk about the AD-AS market.
Let’s break this down into its subsequent parts. Think of the underlying money market
(pictured below). An increase in money supply (M) would shift the real money supply
curve to the right because M increased and P is initially held constant. (In a moment, we
will see how P endogenously changes when M changes.) Using the notation from class,
point z references the interest rate that would exist if there was only a change in M
(holding both P and money demand fixed). If you were to draw the money demandmoney supply graphs, point z would be as follows:
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r0
rz
z
MD(Y0)
M0/P0
M1/P0
However, point z is not a point of equilibrium. The reason is that as r falls, I will increase
causing upward pressure on money demand because the increase in I causes Y to
increase. As firms want more money for investment, the demand for money will
increase.
r0
ra
a
rz
z
MD(Y1)
MD(Y0)
M0/P0
M1/P0
In the IS-LM graph above (main figure 1), point (a) would be the point in the economy if
there were no changes in prices that resulted from the increase in the money supply but
the increase in money supply caused an increase in Y. However, point (a) is not an
equilibrium. The reason is that prices will increase.
In order to induce firms to produce the new investment goods, prices must rise. As
prices rise (and nominal wages are sticky), firms will be willing to produce more. The
rationale for this is that real wages (W/P) temporarily fall. (We know W/P falls because
the denominator increases as P increases). As inputs become relatively cheaper
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(compared to output), firms will optimally chose to produce more. In our model, this is
accomplished by the declining real wage inducing firms to hire more workers (walk
down the labor demand curve). An increase in N will increase Y on the supply side of
the economy.
The labor market analysis is the same as we did in the other demand side examples.
Recall, there is no shift in labor demand (Nd) nor will there be a shift in labor supply
(NS), we just move down the labor demand curve as P increases and W is fixed.
Therefore, the labor market will temporarily be in disequilibrium.
Below, I illustrate the short run of the economy in the AD-SRAS space:
LRAS
SRAS (W0)
P1
1
P0
0
AD(M1)
AD (M0)
Y0*
Y1
Now, let’s revisit out IS-LM graph above (Main Figure1). The increase in P will shift
the LM curve slightly back to the left from LM(M1,P0) to LM(M1,P1) intersecting the IS
curve at point (1).
Note: There is no change in the IS curve. We just move up and down the IS curve .
Why? As r changes, I changes which we represent as a movement ALONG the IS curve.
Let’s consider again what is happening in the money market:
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Note: The points 0, z, a, and 1 all correspond to 0, z, a, and 1 in the IS-LM market (main
figure 1).
r0
r1
ra
rz
0
1
a
z
MD(Y1)
MD(Y0)
M0/P0 M1/P1 M1/P0
Note: As you can see, the money market analysis becomes complicated with all of these
effects. This is why we choose to represent things in the IS-LM market. We do not lose
anything in this analysis because the IS-LM market incorporates all of these shifts –
including the change in Y – in one graph.
What is the net effect on Y in the short run?
We know the net effect on Y is to increase in the short run. The only reason the money
demand (Md) curve shifted right was because Y increased. The only reason that P
increased was because we needed firms to produce more Y (the AD curve shifted out).
Summary: The net effect of an increase in M in the short run is a fall in r and an increase
in Y (via an increase in I) and an increase in P. Below, I have summarized all the short
run effects of an increase in M.
Note: Consumption (C) does not change in this example. You may wonder why C does
not change (and the IS curve shift) given that W/P falls. The reason that C does not
change is because the change in W/P (or the change in Y) is only temporary. Nonliquidity constrained PIH consumers will not respond to temporary changes in income.
The assumption we make is that PVLR does not change with temporary changes in
income In reality, PVLR will change by a very little bit. Our assumption is that such a
change, especially when spread out of the remaining periods of life, is sufficiently small.
Thus, we can ignore it.
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Summary Sheet
Short Run
C
I
G
Y
P
r
M
M/P
W
W/P
N
Long Run
No change (PVLR will not change – the
change in W/P is only temporary).
Increases (as r falls)
No change (G only changes when I tell you
it changes)
Increase (as I increases and C and G are
constant)
Increases (as we induce firms to produce
more)
Falls (that is due to the initial change in M)
Increases (this was the shock)
Increases (the M effect dominates the P
effect because P only increased because Y
increased and Y only increased because r
fell and r only fell because M/P increased).
No change (definition of short run)
Fall (as P increases)
Increases (as W/P falls)
Falls (G is constant and T increases as Y
Deficits increases – this is the intuition behind
cyclical deficits).
No change (only movements ALONG the
IS
IS curve – the effect on I of changes in r is
the reason the IS curve slopes down).
Shifts right
LM
AD
SRAS
Shifts right (M increases)
No change
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What happens to this economy in the long run? Y cannot stay above Y* forever
without the self correcting mechanism kicking in. Eventually, you and I (workers) will
demand higher wages because at the current real wages, we are off our labor supply
curves. The firms will give into our wage demands (if they didn’t they would be off their
labor demand curve as we move back to our labor supply curve at those low real wages –
firms always better off being on their labor demand curve).
The increase in W will cause the SRAS to shift left (as it becomes more expensive to
produce, firms will produce less – this is straight out of your micro class). As SRAS
shifts left, this will cause prices to increase further. Holding demand constant, a fall in
supply will raise prices. This intuition will also be the same as in your micro class. The
rise in prices is necessitated to choke off some of the increase in demand in the economy.
We represent this as a movement ALONG the AD curve. As P increases, Y falls because
the increase in P reduces M/P (holding M fixed at its new level (M1)). This raises interest
rates and reduces investment.
By how much will P increase? P will increase by a sufficiently large amount to make
sure that the change in Y is zero (i.e., P will increase by sufficiently large amount to
return to the economy to Y*). What does this mean? If the change in Y is zero, that
means the change in C plus the change in I plus the change in G must equal zero. In this
example, C and G never changed. So, in the long run, if Y does not change, I must not
change. Given that the autonomous part of I did not change, the only way that I could
return to its original level is if interest rates returned to their original level. P is going to
increase by sufficiently large amount such that M/P returns to its original level. Let’s
graphically illustrate this in the IS-LM market and the AD-AS market.
SRAS(W1)
LRAS
SRAS (W0)
P2
2
P1
1
P0
0
AD(M1)
AD (M0)
Y0*
Y1
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LRAS
LM (M0, P0) = LM(M1,P2)
LM(M1, P1)
r0
0=2
r1
1
IS
Y0*
Y1
Notice: The IS-LM market returns to its initial level (no change in r implies no change
in I and no change in Y).
Although, we didn’t graph it, the labor market returns to equilibrium (from
disequilibrium) at a level of real wages W1/P2 which equals W0/P0. What does this
mean? Given there was no change in labor demand or labor supply, there will be no
change in real wages in the long run (so new real wages must equal the original real
wages).
What has happened to the economy in the long run? None of the real variables in the
economy have changed (Y, C, I, M/P, W/P, r, etc.). That only thing that changed was the
nominal variables (M, P, and W). Moreover, the change in M, P, and W were exactly the
same in percentage terms. If M increased by x%, this implies that both W and P
increased by x% in the long run given that M/P and W/P did not change in the long run.
Our model also yields the quantity theory predictions in the long run. If there is no
change in Y (and velocity is held fixed – that is outside our model), a 1% increase in the
money supply will yield a 1% increase in the price level IN THE LONG RUN (all else
equal). This is exactly the implications of the quantity theory!
This intuition has prompted many researchers (including Nobel Prize winners Bob Lucas
and Milton Friedman) to highlight the neutrality of money in the long run. What does
this mean? It means that a money shock has no effect on the real variables in the
economy in the long run (money – by itself - is neutral to anything we care about) –
changes in the money supply only affects other nominal variables in the long run
(primarily W and P). So, money growth causes inflation and nominal wage growth (and
nothing else). This could be bad if the inflation causes uncertainty and that lowers future
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TFP (as we discussed in week 1). Below I review the long run effects of an increase in
the money supply.
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Summary Sheet
Short Run
C
I
G
No change (PVLR will not change – the
change in W/P is only temporary).
Increases (as r falls)
No change
Increase (as I increases)
Y
P
Increases (as we induce firms to produce
more)
Falls (that is due to the initial change in M)
r
M
M/P
W
W/P
N
Deficits
IS
LM
AD
SRAS
Increases (this was the shock)
Increases (the M effect dominates the P
effect because P only increased because Y
increased and Y only increased because r
fell and r only fell because M/P increased).
No change (definition of short run)
Fall (as P increases)
Increases (as W/P falls)
Falls (cyclical deficits fall as Y increases,
holding G and T constant)
No change (only movements ALONG the
IS curve – the effect on I of changes in r is
the reason the IS curve slopes down).
Shifts right
Long Run
No change (PVLR will not change given that
W/P does not change in long run)
No change (r does not change and Y does not
change)
No change
No change (Y* does not change from an
increase in M so we must return to the original
level of Y (Y*0)
Increases (by more than it did in the short run –
the increase in prices was necessitated to choke
off demand to get us back to Y*).
No change (if Y does not change, then r cannot
change – if r changed, I would change and Y
would change – given that C and G were
constant, this cannot happen – Prices will
change by sufficiently large amount to return
M/P to its original level).
Increase (this was the shock)
No change (the change in M will equal the
change in P leaving M/P constant such that
interest rates return to their original level).
Increase (self correcting mechanism kicks in
when Y > Y*)
No change (in the long run the labor market
will clear).
No change (in the long run, the labor market
will clear at its initial level).
No change (no change in T or G)
No change (just move along the IS curve).
Shifts right (M increases)
No change (the change in P was exactly equal
to the change in M leaving LM unchanged).
Shifts right (as M increases)
No change
Shifts left (as W increases)
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