AP_Krugman_Textbook

Now suppose the money supply increases from M 1 toM 2. In the short run, the econ-
omy moves from E 1 toE 2 and the interest rate falls from r 1 tor 2. Over time, however,
the aggregate price level rises, and this raises money demand, shifting the money de-
mand curve rightward from MD 1 toMD 2. The economy moves to a new long-run equi-
librium at E 3 , and the interest rate rises to its original level of r 1.
How do we know that the long - run equilibrium interest rate is the original interest
rate,r 1? Because the eventual increase in money demand is proportional to the increase
in money supply, thus counteracting the initial downward effect on interest rates. Let’s
follow the chain of events to see why. With monetary neutrality, an increase in the
money supply is matched by a proportional increase in the price level in the long run. If
the money supply rises by, say, 50%, the price level will also rise by 50%. Changes in the
price level, in turn, cause proportional changes in the demand for money. So a 50% in-
crease 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%. Thus, at the initial in-
terest rate of r 1 , the quantity of money demanded rises exactly as much as the money
supply, and r 1 is again the equilibrium interest rate. In the long run, then, changes in
the money supply do not affect the interest rate.

module 32 Money, Output, and Prices in the Long Run 319

Section 6 Inflation, Unemployment, and Stabilization Policies

Module 32 AP Review

Check Your Understanding

1. Suppose the economy begins in long-run macroeconomic
   equilibrium. What is the long-run effect on the aggregate price
   level of a 5% increase in the money supply? Explain.
   2. Again supposing the economy begins in long-run
   macroeconomic equilibrium, what is the long-run effect on the
   interest rate of a 5% increase in the money supply? Explain.

Solutions appear at the back of the book.

Tackle the Test: Multiple-Choice Questions

1. In the long run, changes in the quantity of money affect which
   of the following?
   I. real aggregate output
   II. interest rates
   III. the aggregate price level
   a. I only
   b. II only
   c. III only
   d. I and II only
   e. I, II, and III


2. An increase in the money supply will lead to which of the
   following in the short run?
   a. higher interest rates
   b. decreased investment spending
   c. decreased consumer spending
   d. increased aggregate demand
   e. lower real GDP


3. A 10% decrease in the money supply will change the aggregate
   price level in the long run by
   a. zero.
   b. less than 10%.

c. 10%.

d. 20%.

e. more than 20%.

4. Monetary neutrality means that, in the long run, changes in the
   money supply
   a. can not happen.
   b. have no effect on the economy.
   c. have no real effect on the economy.
   d. increase real GDP.
   e. change real interest rates.


5. A graph of percentage increases in the money supply and
   average annual increases in the price level for various countries
   provides evidence that
   a. changes in the two variables are exactly equal.
   b. the money supply and aggregate price level are unrelated.
   c. money neutrality holds only in wealthy countries.
   d. monetary policy is ineffective.
   e. money is neutral in the long run.