AP_Krugman_Textbook

Figure 32.2 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 E 1 ,

in long - run macroeconomic equilibrium at potential output, and with money supply

M 1. The initial equilibrium interest rate, determined by the intersection of the money

demand curve MD 1 and the money supply curve MS 1 , is r 1.

318 section 6 Inflation, Unemployment, and Stabilization Policies

figure 32.2

The Long -Run Determination of

the Interest Rate

In the short run, an increase in the money supply

fromM 1 toM 2 pushes the interest rate down from

r 1 tor 2 and the economy moves to E 2 , 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 de-

mand at any given interest rate in proportion to the

increase in the aggregate price level, as shown by

the shift from MD 1 toMD 2. 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 E 3 and the interest rate returns to r 1.

Quantity of money

r 1

r 2

Interest

rate, r

MD 2

MD 1

MS 1 MS 2

M 1 M 2

E 2

E (^1) E 3
An increase in the money
supply lowers the interest
rate in the short run...

... but in the long run higher
prices lead to greater money
demand, raising the interest
rate to its original level.

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 eurozone) has a cen-

tral bank that is insulated from political pressure.

All of these central banks try to keep the aggre-

gate price level roughly stable, which usually

means inflation of at most 2% to 3% per year.

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

percentage points per year in 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 per-

centage increases in the aggregate price level.

The figure shows the annual percentage in-

creases 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 1970–2007, with

each point representing a country. If the relation-

ship 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 propor-

tional relationship between money and the aggre-

gate price level. That is, the data support the

concept of monetary neutrality in the long run.

fyi

25%

20

15

10

5

Average

annual

increase in

price level

Average annual increase in money supply

0 5 10 15 20 25 30%

45-degree

line

India

Korea

Iceland

Switzerland

United

States

South

Africa

Australia

Canada Europe

Japan