Through its expansionary and contractionary effects, monetary policy is generally the policy tool of choice to help stabilize the economy. However, not all actions by central banks are productive. In particular, central banks sometimes print money not to fight a recessionary gap but to help the government pay its bills, an action that typically destabilizes the economy.

What happens when a change in the money supply pushes the economy away from, rather than toward, long-run equilibrium? In Chapter 16 we learned that the economy is self-correcting in the long run: a demand shock has only a temporary effect on aggregate output. If the demand shock is the result of a change in the money supply, we can make a stronger statement: in the long run, changes in the quantity of money affect the aggregate price level, but they do not change real aggregate output or the interest rate. To see why, let’s look at what happens if the central bank permanently increases the money supply.

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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 the interest rate. In assessing 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 19-11 shows the short-run and long-run effects of an increase in the money supply when the economy begins at potential output, Y₁. The initial short-run aggregate supply curve is SRAS₁, the long-run aggregate supply curve is LRAS, and the initial aggregate demand curve is AD₁. The economy’s initial equilibrium is at E₁, 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, Y₁.

Now suppose there is an increase in the money supply. Other things equal, an increase in the money supply reduces the interest rate, which increases investment spending, 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 AD₂. In the short run, the economy moves to a new short-run macroeconomic equilibrium at E₂. The price level rises from P₁ to P₂, and real GDP rises from Y₁ to Y₂. That is, both the aggregate price level and aggregate output increase in the short run.

But the aggregate output level, Y₂, is above potential output. As a result, nominal wages will rise over time, causing the short-run aggregate supply curve to shift leftward. This process stops only when the SRAS curve ends up at SRAS₂ and the economy ends up at point E₃, a point of both short-run and long-run macroeconomic equilibrium. The long-run effect of an increase in the money supply, then, is that the aggregate price level has increased from P₁ to P₃, but aggregate output is back at potential output, Y₁. In the long run, a monetary expansion raises the aggregate price level but has no effect on real GDP.

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We won’t describe the effects of a monetary contraction in detail, but the same logic applies. In the short run, a fall in the money supply leads to a fall in aggregate output as the economy moves down the short-run aggregate supply curve. In the long run, however, the monetary contraction reduces only the aggregate price level, and real GDP returns to potential output.

How much does a change in the money supply change the aggregate price level in the long run? The answer is that a change in the money supply leads to an equal proportional change in the aggregate price level in the long run. If the money supply falls 25%, the aggregate price level falls 25% in the long run; if the money supply rises 50%, the aggregate price level rises 50% in the long run.

How do we know this? Consider the following thought experiment: suppose all prices in the economy—prices of final goods and services and also factor prices, such as nominal wage rates—double. And suppose the money supply doubles at the same time. What difference does this make to the economy in real terms? The answer is none. All real variables in the economy—such as real GDP and the real value of the money supply (the amount of goods and services it can buy)—are unchanged. So there is no reason for anyone to behave any differently.

We can state this argument in reverse: if the economy starts out in long-run macroeconomic equilibrium and the money supply changes, restoring long-run macroeconomic equilibrium requires restoring all real values to their original values. This includes restoring the real value of the money supply to its original level. So if the money supply falls 25%, the aggregate price level must fall 25%; if the money supply rises 50%, the price level must rise 50%; and so on.

This analysis demonstrates the concept known as monetary neutrality, in which changes in the money supply have no real effects on the economy. In the long run, the only effect of an increase in the money supply is to raise the aggregate price level by an equal percentage. Economists argue that money is neutral in the long run.

This is, however, a good time to recall the dictum of John Maynard Keynes: “In the long run we are all dead.” In the long run, changes in the money supply don’t have any effect on real GDP, interest rates, or anything else except the price level. But it would be foolish to conclude from this that the Fed is irrelevant. Monetary policy has powerful real effects on the economy in the short run, often making the difference between recession and expansion. And that matters a lot for society’s welfare.

In the short run, an increase in the money supply leads to a fall in the interest rate, and a decrease in the money supply leads to a rise in the interest rate. In the long run, however, changes in the money supply don’t affect the interest rate.

Figure 19-12 shows why. It 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 E₁, in long-run macroeconomic equilibrium at potential output, and with money supply ₁. The initial equilibrium interest rate, determined by the intersection of the money demand curve MD₁ and the money supply curve MS₁, is r₁.

Now suppose the money supply increases from ₁ to ₂. In the short run, the economy moves from E₁ to E₂ and the interest rate falls from r₁ to r₂. Over time, however, the aggregate price level rises, and this raises money demand, shifting the money demand curve rightward from MD₁ to MD₂. The economy moves to a new long-run equilibrium at E₃, and the interest rate rises to its original level at r₁.

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And it turns out that the long-run equilibrium interest rate is the original interest rate, r₁. We know this for two reasons. First, due to monetary neutrality, in the long run the aggregate price level rises by the same proportion as the money supply; so if the money supply rises by, say, 50%, the price level will also rise by 50%. Second, the demand for money is, other things equal, proportional to the aggregate price level.

So a 50% increase in the money supply raises the aggregate price level by 50%, which increases the quantity of money demanded at any given interest rate by 50%. As a result, the quantity of money demanded at the initial interest rate, r₁, rises exactly as much as the money supply—so that r₁ is still the equilibrium interest rate. In the long run, then, changes in the money supply do not affect the interest rate.

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