Activity 41

1. Activity 41 The neutrality of money

2. Money is neutral • In the long run changes in money supply will only change price level and have no change on real output

3. In the short run, explain what happens to real output. Suppose that initially the economy is at the intersection of AD and SRAS, and the Fed decides to implement an expansionary policy to increase the level of employment LRAS SRAS PRICE LEVEL AD REAL GDP

4. In the short run, explain what happens to real output. REAL OUTPUT SHOULD GROW With the decrease in interest rates because of increased MS, the interest rate sensitive components of aggregate demand (consumption and investment) will increase thereby increasing output Suppose that initially the economy is at the intersection of AD and SRAS, and the Fed decides to implement an expansionary policy to increase the level of employment LRAS SRAS PRICE LEVEL AD 1 AD REAL GDP

5. In the short run, explain what happens to the price level. Suppose that initially the economy is at the intersection of AD and SRAS, and the Fed decides to implement an expansionary policy to increase the level of employment LRAS SRAS PRICE LEVEL AD REAL GDP

6. In the short run, explain what happens to the price level. PRICE LEVEL WILL INCREASE An increase in demand can only be met if firms have an incentive to increase production. A price increase provides that incentive Suppose that initially the economy is at the intersection of AD and SRAS, and the Fed decides to implement an expansionary policy to increase the level of employment LRAS SRAS PRICE LEVEL AD 1 AD REAL GDP

7. In the short run, explain what happens to employment and nominal wages. Suppose that initially the economy is at the intersection of AD and SRAS, and the Fed decides to implement an expansionary policy to increase the level of employment LRAS SRAS PRICE LEVEL AD REAL GDP

8. In the short run, explain what happens to employment and nominal wages. EMPLOYMENT WILL INCREASE WHILE NOMINAL WAGES REMAIN UNCHANGED. Firms need to hire more labor to increase output while workers do not yet realize that price level has risen Suppose that initially the economy is at the intersection of AD and SRAS, and the Fed decides to implement an expansionary policy to increase the level of employment LRAS SRAS PRICE LEVEL AD 1 AD REAL GDP

9. In the short run, explain what happens to nominal interest rates and real interest rates. Suppose that initially the economy is at the intersection of AD and SRAS, and the Fed decides to implement an expansionary policy to increase the level of employment LRAS SRAS PRICE LEVEL AD REAL GDP

10. In the short run, explain what happens to nominal interest rates and real interest rates. BOTH THE NOMINAL AND THE REAL INTEREST RATES DECLINE The increase in money supply causes nominal rates to initially decline while demand for money is constant The real interest rate (which had been equal to the nominal interest rate with no inflation) now declines because of the decrease in nominal interest rates and increase in price level Real = nominal (down) – inflation (up) Suppose that initially the economy is at the intersection of AD and SRAS, and the Fed decides to implement an expansionary policy to increase the level of employment LRAS SRAS PRICE LEVEL AD1 AD REAL GDP

11. In the long run, explain what happens to real output. Suppose that initially the economy is at the intersection of AD and SRAS, and the Fed decides to implement an expansionary policy to increase the level of employment LRAS SRAS PRICE LEVEL AD REAL GDP

12. In the long run, explain what happens to real output. REAL OUTPUT RETURNS TO THE FULL EMPLOYMENT LEVEL As workers recognize the increased price level, they demand and get wage increases. This in turn increases production costs and short run aggregate supply decreases Suppose that initially the economy is at the intersection of AD and SRAS, and the Fed decides to implement an expansionary policy to increase the level of employment SRAS 1 LRAS SRAS PRICE LEVEL AD 1 AD REAL GDP

13. In the long run, explain what happens to the price level. Suppose that initially the economy is at the intersection of AD and SRAS, and the Fed decides to implement an expansionary policy to increase the level of employment LRAS SRAS PRICE LEVEL AD REAL GDP

14. In the long run, explain what happens to the price level. PRICE LEVEL REMAINS HIGH Nominal wages are now in alignment with the higher price level Suppose that initially the economy is at the intersection of AD and SRAS, and the Fed decides to implement an expansionary policy to increase the level of employment SRAS 1 LRAS SRAS PRICE LEVEL AD 1 AD REAL GDP

15. In the long run, explain what happens to employment and nominal wages. Suppose that initially the economy is at the intersection of AD and SRAS, and the Fed decides to implement an expansionary policy to increase the level of employment LRAS SRAS PRICE LEVEL AD REAL GDP

16. In the long run, explain what happens to employment and nominal wages. EMPLOYMENT IS AT THE FULL EMPLOYMENT LEVEL AND NOMINAL WAGES HAVE RISEN Nominal wages rise so that real wages given them the same purchasing power Suppose that initially the economy is at the intersection of AD and SRAS, and the Fed decides to implement an expansionary policy to increase the level of employment SRAS 1 LRAS SRAS PRICE LEVEL AD 1 AD REAL GDP

17. In the long run, explain what happens to the nominal interest rate and the real interest rate. Suppose that initially the economy is at the intersection of AD and SRAS, and the Fed decides to implement an expansionary policy to increase the level of employment LRAS SRAS PRICE LEVEL AD REAL GDP

18. In the long run, explain what happens to the nominal interest rate and the real interest rate. The real interest rate returns to its normal level (in the US between 2% and 3%). Nominal rates rise to include the inflation rate and the real interest rate Suppose that initially the economy is at the intersection of AD and SRAS, and the Fed decides to implement an expansionary policy to increase the level of employment LRAS SRAS PRICE LEVEL AD REAL GDP