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Inflation, Unemployment, and Stabilization Policies: Money, Output, and Prices in the Long Run

Inflation, Unemployment, and Stabilization Policies: Money, Output, and Prices in the Long Run. AP Economics Mr. Bordelon. Short-Run and Long-Run Effects of an Increase in MS.

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Inflation, Unemployment, and Stabilization Policies: Money, Output, and Prices in the Long Run

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  1. Inflation, Unemployment, and Stabilization Policies:Money, Output, and Prices in the Long Run AP Economics Mr. Bordelon

  2. Short-Run and Long-Run Effects of an Increase in MS If they act stupidly, a central bank can engage in monetary policy that might move the economy away from potential GDP rather than closer to potential GDP. Economy is currently in LRE. If Fed conducts expansionary monetary policy, interest rate decreases. Lower interest rates shift AD to the right. In short run, real GDP and APL increase. Nominal wages increase, and SRAS shifts left. LRE re-established back at YP at a higher APL. In the long run, expansionary monetary policy DOES NOT increase real GDP, but causes inflation. Under the same analysis with contractionary monetary policy, we would see that In short run, real GDP and APL decrease. In the long run, contractionary monetary policy DOES NOT decrease real GDP, but does cause deflation.

  3. Money Neutrality • Money neutrality. Changes in MS have no real effects on the economy. In the long run, the only effect of an increase in MS is to increase APL by an equal percentage. With this phenomenon, economists argue that money is neutral in the long run. • Example. All price in the economy double. Price of final g/s, factor prices all double. • MS doubles at the same time. • In real terms, there is no effect on the economy. All real variables are unchanged. • As such, no incentive for anyone to change their behavior. • The opposite is also true. If MS increases by any given percentage, in the long run, APL increases by same percentage.

  4. Changes in MS and Interest Rate in Long Run In short run, increase in MS causes nominal interest rates to decrease. Looking at it in the long run, however, we see something different. Example. Money market is in equilibrium at interest rate r1. MS1 increases by 10% to MS2. Nominal interest rate decreases. Money neutrality says that in the long run, APL increases by 10%. When APL increases by 10%, households increase MD by 10%. MS and MD both shift right by 10%. LRE interest rate returns to r1. In the long run, money neutrality says that the interest rate will not change after a change in MS.

  5. Question 1 • Draw a correctly labeled graph of AD and AS showing an economy in LRE. • Draw a correctly labeled graph of equilibrium in the money market. • On the money market graph, show what happens to the money market in the short run in the central bank decreases MS. • On the AD-AS graph, show what happens to the macroeconomy in the short run if the central bank decreases MS. • On both graphs, show what will happen in the long run. Explain these adjustments.

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