AP_Krugman_Textbook

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 for the interest rate. In as-

sessing 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 32.1 shows the short -run and long -run effects of an increase in the money

supply when the economy begins at potential output, Y 1. The initial short -run aggregate

supply curve is SRAS 1 , the long -run aggregate supply curve is LRAS,and the initial ag-

gregate demand curve is AD 1. The economy’s initial equilibrium is at E 1 , 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, Y 1.

Now suppose there is an increase in the money supply. Other things equal, an in-

crease in the money supply reduces the interest rate, which increases investment spend-

ing, 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 AD 2. In the short run, the economy moves to a new short - run

macroeconomic equilibrium at E 2. The price level rises from P 1 toP 2 , and real GDP

rises from Y 1 toY 2. That is, both the aggregate price level and aggregate output increase

in the short run.

But the aggregate output level Y 2 is above potential output. As a result, nominal

wages will rise over time, causing the short - run aggregate supply curve to shift left-

ward. This process stops only when the SRAScurve ends up at SRAS 2 and the economy

ends up at point E 3 , a point of both short - run and long - run macroeconomic equilib-

rium. The long -run effect of an increase in the money supply, then, is that the aggre-

gate price level has increased from P 1 toP 3 , but aggregate output is back at potential

316 section 6 Inflation, Unemployment, and Stabilization Policies

figure 32.1

The Short -Run and Long -Run

Effects of an Increase in the

Money Supply

An increase in the money supply generates

a positive short -run effect, but no long -run

effect, on real GDP. Here, the economy be-

gins at E 1 , a point of short - run and long - run

macroeconomic equilibrium. An increase in

the money supply shifts the ADcurve right-

ward, and the economy moves to a new

short -run equilibrium at E 2 and a new real

GDP of Y 2. But E 2 is not a long - run equilib-

rium:Y 2 exceeds potential output, Y 1 , lead-

ing over time to an increase in nominal

wages. In the long run, the increase in nom-

inal wages shifts the short - run aggregate

supply curve leftward, to a new position at

SRAS 2. The economy reaches a new short -

run and long - run macroeconomic equilib-

rium at E 3 on the LRAScurve, and output

falls back to potential output, Y 1. The only

long - run effect of an increase in the money

supply is an increase in the aggregate price

level from P 1 toP 3.

Aggregate

price

level

SRAS 2

SRAS 1

LRAS

Y 1 Y 2

Potential

output

P 3

E 3

E 1

E 2

P 1

P 2

AD 2

An increase in the

money supply reduces

the interest rate and

increases aggregate

demand...

... but the eventual
rise in nominal wages
leads to a fall in
short-run aggregate
supply and aggregate
output falls back to
potential output.

Real GDP

AD 1