Money, Output, and Prices in the Long Run

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 an earlier chapter 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.

Short-Run and Long-Run Effects of an Increase in the Money Supply

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, first introduced in Chapter 12.

Figure 15-11 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.

The Short-Run and Long-Run Effects of an Increase in the Money Supply When the economy is already at potential output, an increase in the money supply generates a positive short-run effect, but no long-run effect, on real GDP.
Here, the economy begins at E1, a point of short-run and long-run macroeconomic equilibrium. An increase in the money supply shifts the AD curve rightward, and the economy moves to a new short-run macroeconomic equilibrium at E2 and a new real GDP of Y2. But E2 is not a long-run equilibrium: Y2 exceeds potential output, Y1, leading over time to an increase in nominal wages. In the long run, the increase in nominal wages shifts the short-run aggregate supply curve leftward, to a new position at SRAS2.
The economy reaches a new short-run and long-run macroeconomic equilibrium at E3 on the LRAS curve, and output falls back to potential output, Y1. When the economy is already at potential output, the only long-run effect of an increase in the money supply is an increase in the aggregate price level from P1 to P3.

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.

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.

Monetary Neutrality

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. For example, 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.

According to the concept of monetary neutrality, changes in the money supply have no real effects on the economy.

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 does have 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.

Changes in the Money Supply and the Interest Rate in the Long Run

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 15-12 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 . The initial equilibrium interest rate, determined by the intersection of the money demand curve MD1 and the money supply curve MS1, is r1.

The Long-Run Determination of the Interest Rate In the short run, an increase in the money supply from to pushes the interest rate down from r1 to r2 and the economy moves to E2, a short-run equilibrium. In the long run, however, the aggregate price level rises in proportion to the increase in the money supply, leading to an increase in money demand at any given interest rate in proportion to the increase in the aggregate price level, as shown by the shift from MD1 to MD2. The result is that the quantity of money demanded at any given interest rate rises by the same amount as the quantity of money supplied. The economy moves to long-run equilibrium at E3 and the interest rate returns to r1.

Now suppose the money supply increases from to . 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.

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.

!worldview! ECONOMICS in Action: International Evidence of Monetary Neutrality

International Evidence of Monetary Neutrality

These days monetary policy is quite similar among wealthy countries. Each major nation (or, in the case of the euro, the euro area) has a central bank that is insulated from political pressure. All of these central banks try to keep the aggregate price level roughly stable, which usually means inflation of at most 2% to 3% per year.

The Long-Run Relationship Between Money and InflationSource: Federal Reserve Bank of St. Louis.

But if we look at a longer period and a wider group of countries, we see large differences in the growth of the money supply. Between 1970 and the present, the money supply rose only a few percent per year in some countries, such as Switzerland and the United States, but rose much more rapidly in some poorer countries, such as South Africa. These differences allow us to see whether it is really true that increases in the money supply lead, in the long run, to equal percent rises in the aggregate price level.

Figure 15-13 shows the annual percentage increases in the money supply and average annual increases in the aggregate price level—that is, the average rate of inflation—for a sample of countries during the period 1981–2013, with each point representing a country. If the relationship between increases in the money supply and changes in the aggregate price level were exact, the points would lie precisely on a 45-degree line.

In fact, the relationship isn’t exact, because other factors besides money affect the aggregate price level. But the scatter of points clearly lies close to a 45-degree line, showing a more or less proportional relationship between money and the aggregate price level. That is, the data support the concept of monetary neutrality in the long run.

Quick Review

  • According to the concept of monetary neutrality, changes in the money supply do not affect real GDP, they only affect the aggregate price level. Economists believe that money is neutral in the long run.

  • In the long run, the equilibrium interest rate in the economy is unaffected by changes in the money supply.

15-4

  1. Question 15.8

    Assume the central bank increases the quantity of money by 25%, even though the economy is initially in both short-run and long-run macroeconomic equilibrium. Describe the effects, in the short run and in the long run (giving numbers where possible), on the following.

    1. Aggregate output

    2. Aggregate price level

    3. Interest rate

  2. Question 15.9

    Why does monetary policy affect the economy in the short run but not in the long run?

Solutions appear at back of book.

PIMCO Bets on Cheap Money

Pacific Investment Management Company, generally known as PIMCO, is one of the world’s largest investment companies. Among other things, it runs PIMCO Total Return, the world’s largest mutual fund. Bill Gross, who headed PIMCO from 1971 until 2014, was legendary for his ability to predict trends in financial markets, especially bond markets, where PIMCO does much of its investing.

In the fall of 2009, Gross decided to put more of PIMCO’s assets into long-term U.S. government bonds. This amounted to a bet that long-term interest rates would fall. This bet was especially interesting because it was the opposite of the bet many other investors were making. For example, in November 2009 the investment bank Morgan Stanley told its clients to expect a sharp rise in long-term interest rates.

What lay behind PIMCO’s bet? Gross explained the firm’s thinking in his September 2009 commentary. He suggested that unemployment was likely to stay high and inflation low. “Global policy rates,” he asserted—meaning the federal funds rate and its equivalents in Europe and elsewhere—“will remain low for extended periods of time.”

PIMCO’s view was in sharp contrast to those of other investors: Morgan Stanley expected long-term rates to rise in part because it expected the Fed to raise the federal funds rate in 2010.

Who was right? PIMCO, mostly. As Figure 15-14 shows, the federal funds rate stayed near zero, and long-term interest rates fell through much of 2010, although they rose somewhat very late in the year as investors became somewhat more optimistic about economic recovery. Morgan Stanley, which had bet on rising rates, actually apologized to investors for getting it so wrong.

The Federal Funds Rate and Long-Term Interest Rates, 2009–2011Source: Federal Reserve Bank of St. Louis.

Bill Gross’s foresight, however, was a lot less accurate in 2011. Anticipating a significantly stronger U.S. economy by mid-2011 that would result in inflation, Gross bet heavily against U.S. government bonds early that year. But this time he was wrong, as weak growth continued. By late summer 2011, Gross realized his mistake as U.S. bonds rose in value and the value of his funds sank. He admitted to the Wall Street Journal that he had “lost sleep” over his bet, and called it a “mistake.” It was a mistake from which he never fully recovered. Most observers agreed that the losses PIMCO suffered from Gross’s bad bet in 2011 played a major rule in his departure in 2014.

QUESTIONS FOR THOUGHT

  1. Question 15.10

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    Why did PIMCO’s view that unemployment would stay high and inflation low lead to a forecast that policy interest rates would remain low for an extended period?

  2. Question 15.11

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    Why would low policy rates suggest low long-term interest rates?

  3. Question 15.12

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    What might have caused long-term interest rates to rise in late 2010, even though the federal funds rate was still zero?