differences

SHORT ANSWER (200 words or less): Explain the differences between the long run and short run aggregate supply curves. Consider these differences, and explain how an expansionary gap occurs? 

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L*2 tu{omey and Aggregat*
ffi*g”xland in the SF:*r”t Run
in the short rut’t,maney affe$s the ecanawy thraugh
changes in the interest rale. Monetary policy influ

–

ences the market interest rate, which in turn affects
investment, a component of aggregate demand. Let’s
work through the chain of causation.

$mterest ffimtes effid fis?w_.estmeffit
Suppose the Fed believes that the economy is pro-
ducing less than its potential and decides to stim-
ulate output and employment by increasing the
money supply. Recall from the previous chapter that
the Fed’s primary tool for increasing the money sup-
ply is open-market purchases of U.S. government
securities. The three panels of Exhibit 3 trace the
iinks between changes in the money supply and
changes in aggregate demand. We begin with equi-
librium interest rate i, which is determined in panel
(a) by the intersection of the money demand curve
D. with the money supply curve S,n. Suppose the
Fed purchases U.S. government bonds and thereby
increases the money supply, as shown by a rightward
shift of the money supply curve from S. to S’-. After
the increase in the supply of money, people are hold-
ing more money than they would prefer at interest
rate i, so they try to exchange one form of wealth,
money, for other f,nancial assets. Exchanging doilars
for financial assets has no direct effect on aggregate
demand, but it does reduce the market interest rate.

A decline in the interest rate to i’, other things
constant, reduces the opportunify cost of financ-

i,,:’< iiii:i'L t Effects of an lncrease in the Money Supply on lnterest Rates, lnvestment, and Aggregate Demand

(a) Supply and demand
for money

ing new plants and equipment, thereby making
investment more profitabie. Likewise, a lower inte
rate reduces the cost of financing a new house. f
deciine in the interest rate increases the amoun
investment demanded. Panel (b) shows the dem
for investment Dr flrst introduced several chap
back.When the interest rate falis from ito i’, the qr_
tiry of investment demanded increases from I to I

The spending multiplier magnifies this incre
in investment, leading to a greater increase in ag

1

gate demand, reflected in panel (c) by a rightw
shift of the aggregate demand curve from AD to t
At the given price levei P, real GDP increases fror
to Y’.

The secuet.rce of evelrts can
l;e sumi”ealized as foliou.’s:

:::. : :”_’::: :
‘,.,,.’, |-,’ .,.,

;r:: g::141;.itji,.ljif;.Jiil=j,y,f ., :.,,”..,.., r i
1.’*;i *,, r, … \:: ;:::.,. :,,.,,,.,.,,,,,.,,’t,i’l’.,’,,,
z, ieaucino*i-b.intriie’ ?iie, r

*:,,,iiri+b.-a,.9 9€sei.e!S*a1@{_f:iqAp$.,r:,,
,S,,:atagii i*iieffi;,$l€Br.deitianbgq@Sestfioni. rrs,j

The entire s€quence is also traced out in each panel of Exhibit 3 b
. ‘their{tbl.4n1gl-rtlfioqr, p, gqr! arlqjFqi.:ntjb; .,l r ,r;, . , ;r” .”, -. -r ,, .:, , .:-:ri :: ,-,..:.i.,i;.:l:::::in::r.: ,:.-::..:i:.;:,i’.:ui:.:::.,i i,ll::,: tj.f-:rr:,::’: t.r.ttalt:ij:.)-:

Note that the graphs prbsented here ignr
any feedback effects of changes in real GDP on i
demand for money. Because the demand for mor
depends on the levei of real GDP, an increase
real GDP would shift the money demand curve
the right in panel (a). If we had shifted the mor

q)

(o

o
9/
c)
CI

(b) Demand for
investment

(c)Aggregate
demand

0 M M’ Money

23O FAR’I 3 Fiscai arid lFoneiary Policy

1′ lnvestment Real GDP

demand curve’ the equilibrium lnterest
rate would stijl have fallen, but nol by
as much, so investment and aggregate
demand would not have increased by as

much. Thus, Exhibit 3 is a simplified view’

but it still captures the essentials of how
changes in the money supply affect the
economy.

Now let’s consider the effect of a Fed-

orchestrated increase in interest rates’ In
Exhibit 3 such a policy could be traced by

moving from point b to point a in each
panel,lut we dispense with a blow-by-
tlow discussion of the graphs’ Suppose
the Federal Reserve decides to reduce the

money supply to cool down an overheated

economy. A decrease in the money sup-
p1y would increase the interest rate’ At
in” frigtl”t interest rate, businesses find it
more iostly to finance plants and equip-
ment, and households find it more costly to

frnance new homes. Hence, a higher inter-

est rate reduces the amount invested’ The 0
resulting decline in investment is magni-

fied by the spending muitiplier, leading to

”
gr””t”t decline in aggregate demand’

As long as the interist rate is sensitive to changes
in

the money supply, and as Tong as investment is sensitiue
to

changes in the interest rate, changes in the money supply

affeci investment. The extent to which a given change

in investment affects aggregate demand depends
on

the size of the spending multiplier’

F :’l r’ tilrl { ,j
Expansionary Monetary Policy to Close a

Contractionary Gap

Potential
output
LRAS

o 130
o
o
O

E 12s

13.8 14.0
\-/J

ContractionarY gaP

price level of rz5 is below the expected price
level of

r3o, und the short-run equilibrium oufPlt, of $rg’8

trition is below the economy’s potential of $r+’o
tril-

lion, yielding a contractionary gap of $o-z trillion’

–

al p”i”*, real wages are higher than had been

negod;ted and many people are looking
for jobs’

fne fed can wait to see whether the economy recov-

ers on its own. Market forces could cause employers

and workers to renegotiate lower nominal wages’

This would lower pioduction costs’ pushing the

short-run aggregate supply curve rightward’ thus

.i”rl”g-irt”
“.”onitu.tionity g”p But if Fed officials

are im-patient with natural market forces’ they
could

try to close the gap using an expansionary
monetary

fofi.y. ror “xamp1e,
aulng zooT and zoo8′ the Fed

‘uggr”rsirr”ty cut the federal funds rate to stimuiate

;;;;;;” 6emand. if the Fed lowers that rate bv

;.iri tt” right amount, this stimulates investment’
th.r, incr”Jring the aggregate demand curve enough

to achieve a new “q,’i1iUti”*
at point b’ where the

;”;;;y produces its potential output’ Given all
the connections in the chain of causality between

changes in the money suppiy and changes in
equi-

libriu”m output, however, it would actually be quite

remarkable for the Fed to execute monetary
policy

so precisely. If the Fed overshoots the mark and
stimulates aggregate demand too much’ this would

;;;; ;p
“n

-“”*pittionary gap, thus creating infla-

tionary pressure in the economy’

*:,
;;13.

i.:

.e
i:

tt

i’
:::,

*
,’tt

:r:
i

1

AddEmg the S$noYt-Run
Aggregate SuPP$Y easrve
Even after tracing the effect of a change in the
money supply on aggregate demand,-we still have

only half tt
”

ttoty. To determine the effects of mon-

etary policy on the equilibrium real GDP in the econ-

o*y, *u need the supply side’ An-aggregate supply
curve helps show how a given shift of the aggregate

demand iurve affects real GDP and the price level’

In the short run, the aggregate supply curve slopes

upward, so the quantity supplied in-c1-eas-es only if
the price level increases. For a given shift of the aggre-

gate demand’ curve, the steeper the short’run aggregate

iuppty curve, the smaller the increase tn real GDP and the

larger the increase in the price level’ ,
Suppose the economy is producing at point o in

rxhibiii, where the aggregate demand cuwe AD inter-
sects the short-run aggregate supply curve SRASlqo’

pelding a shcrt-ntn equiiibrium output of $r:’8 tril-

li”,t *.,I a ::t:e -e’;ei cf r 25. As you can see, the actual

f iiA?’I’ER :5 231

l#s Frloney and Aggregate
Fernamd in the Long Rren

gate suPPlY curve is
fixed at the economY’s
potential outPut, this
greater sPending sim-
ply increases the Price
level. In short, more
money is chasing the
same output’ Here are
the details.

equaticn of
efchange
the quafititY ol moneY.
i14, nrultip:ied tly its v€-
tocity, V equals nominal
GDE which is the Ptod-
uct of the Priee le*;el. f,
and real &DEY; or M x
V=PxY
velocity of n:oneY
the average number ef
times Per Year each dol’
lar is used tQ Plrchase
final goods and se:vices

u

l-
U(,
u
F
@v()
oF
U)
o

232 PART 3 Fiscal and Mcneiary Policy

*”rd,
“r,

increase in the money supply reduces the

market interest rate, increasing investment
and

consequently increasing aggregate demand’
And as

tong as the short-run aggregate,supply curve siopes

upi^rd, the short-run effect of an increase in the
.riot”y suppty is an increase in both real output and

the piice ievel. gut here is one final qualification:
Lowering the interest rate may not always stimu-

]ate investment. Economic prospects may become so

glum that lower interest rates may fail to achieve
the

iesired increase in aggregate demand’ In Japan’ for

example, the central bank lowered the interest rate

nearty to zero, yet that economy remained li’feiess
for years during the r99os’

\srqrs\qrrs-\-s\ss-qr:s\e\ss\q\\qrsgrr-.
qrr’trre’

and the investment demand curve each slope
down-

\h-qLqdreaaf, L’*aktawtqe
Every transaction in the economy invoives a tt…-i–+?ri

swai: the buyer exchanges money for goods a::
the seiter exchanges goods for money’ one

way c –

“”pt”tti.tg
this relationship among key variables in

thi econolny is the cquation of exchange’.frrst devel’

oped byclassicai economists’ Although this equation

can be’arranged in different ways, depending on the

emphasis, the basic version is

MXV=PXY

where M is the quantity of money in the economy; V
is

the velocity ef money, or the average number of times

per year each dollar is used to purchase final goods

andieruices; P is the average price level; and Y is
real

GDP. The equation of exchange says that the quantity

of money in circulatiorl’ M. muitiplied by V’ the num-

ber of times that money changes hands’ equals the

average price level, P, times real output, Y The
price

level,-g iimes real output, ! equals the economy’s
nominal income and output’ or nominal GDP’

By rearranging the equation of exchange’ we find

that velocity equats nominal GDP divided by the

money stock, or:

When we looked at the impact of money on

the economy in the short run’ we found that
money influlnces aggregate demand and equi-

librium output through its effect on the interest

rate. Here we look at the long-run effects of changes

in the money supply on the economy’ The long-run

view of money is more direct: if the central
bank sup-

plies more money to the economy, sooner or later

peopte spend more’ But because the long-run
agge-

DvV
\f

–
–

v-
M

For example, nominal GDP in zoo8 was $r+’3 trillion’

and the money stock as measured by Mr averaged

F*$

.:tr
!*’
:$:.::

iitr-t:

,,.#.

5:”6 trillion. The velocitY
:.: money indicates how
::::en each dollar is used
;3 average to PaY for final
.;ods and services during
–:e year. So in zoo8, veloc-
-:.; was $r+.3 trillion divided
:.; Sr.6 trillion, or 8.9. Given
-fP and the moneY suP-
:…’, each dollar in circula-
::–n must have been spent
3 ; times on average to PaY
::: final goods and services.

, =;ues of the other variables’
-::::dentally, velocitY mea-
: tr:es spending oniY on final

“:cds and services-not
on intermediate products

,

:,=::ndhand goods, or financial assets, even though
.-:r spending also occurs. So velocity underesti-
:-raies how hard the money supply works during the

“-a:.

The equation of exchange saYS
‘::: iota] spending (M x V) is alwaYs

::–.iai to total receipts (P x Y), as was
::-n .ase in our circuiar-flow analY-
::-:. rs described so far, however, the

=-,;aiion of exchange is simPlY an
;:r.:ry-a relationship exPressed
:. s;ch a way that it is true bY
:=::::ition. Another examPle of an

-:=i::ity wouid be a relationshiP
.: -aiing miles per gallon to the
:-i:rnce driven divided bY the
:.-:line required.

?he Suarnt$ty
Th*orgr of Mc>meY

the economy’s potential level of output’ With reai
output, Y fixed and the velocity of money, V, rela-
tively stable, a change in the stock of money trans-
lates directly into a change in the price level’ Exhibit

5 on the next page shows the effect of an increase

in the money supply in the long run. An increase in

the money iupply causes a rightward shift of the
aggregate demand curve, which increases the price

level but leaves output unchanged

So an i.ncrease in the
money supPlY results in
more spending in the long
rLin, meaning a higher
nominal GDP. How is this
increaseinPxYdivided
between changes in the
price level and changes
in real GDP? The answer
does not lie in the quan-
tity theory for that theory
is stated onlY in terms of
nominai GDP. The answer
lies in the shaPe of the
aggregate suPPiY curve.

The long-run aggregate
supply curve is vertical at

at potential GDP. So the economY’s
potential output level is not affected
by changes in the money suPPlY’ In
the long run, increases in the moneY
supply, with velocittl stable or at least
not decreqsing, result only in higher
prices. For example, an examination
of 73 inflation periods across major
economies since r96o concludes that
important triggers to inflation were
expansionary monetary Policies-

To review: If velocity is stable, or at
least predictable, the quantity theory of
money says that changes in the money sup-

quantity theorY
of money
if the vei*eitY o{ nrtl*eY
is st;tble, 0r at least
!:l’*dictahle, ehang*s in
ih€ m*lreY suPPll have
prad;ctaili€ *f{ects on
nami*al GBP

rri3€== a

liXV:pXy

7:PxvF

.: ‘i:iccity is reiatively stable over time, or at least
::=;:ctable, the equation ofexchange turns from an
-:=::iqy into a theory-the quantity theory of money.
l::: :,rar:ti{r t}:*ory af mo*ey states that if the veloc-
.:,- ;: :noney is stable, or at least predictable, then
::.= :quation of exchange can be used to predict the
::::;:s of changes in the money supply on nominal
,ll. ? x Y For example, if M increases by 5 percent
::-i -ut remains constant, then P x Y or nominal GDP,
:– -:r: also increase by 5 percent. For a while, some
:-::::mists believed they could use the equation of
=:,:iange to predict nominal output in the short run.
:;:;’ ii’s used primarily as a guide in the iong run.

ply r.r.rill, in the long run, result in predictable effects on the

economy’s price leve| Velocity’s stability and predict-
ability are key to the quantity theory of money’

What Betermimes the \fele>c$tY
of Money?
Velocity depends on the
customs and conventions
of commerce. In colonial
times, money might be tied
up in transit for daYs as a
courier on horseback carried
a payment from a merchant

H;.’::

CHAPTER I6 l\4cneiary ‘i”hurrry ;ind l’ciiry 233

Lxirii:it 3
ln the Long Run, an lncrease in the Money Supply

Besults in a Higher Price Level, or lnflation

in Boston to one in Baltimore. Today, the electronic
transmission of funds occurs in an instant, so the
same stock of money can move around much more
quickly to finance many more transactions’ The
uelociry of money has also increased because of a vari’

ety of commercial innovations that facilitate exchange’
for exampie, a wider use of charge accounts and
credit cards has reduced the need for shoppers to
carry cash. Likewise, automatic teiler machines have

made cash more accessible at more times and in
more places. What’s more, debit cards are used at
a growing number of retail outiets, such as grocery

stores and drug stores, so people *eed less “walking

130

around” money.
Another institutional

factor that determines
velocity is the frequencY
with which workers get
paid. Suppose a worker
who earns $5z,ooo Per
year gets paid $z,ooo every
two weeks. Earnings are
spent evenlY during the
two-week period and are

other things constant. Money becomes a hc:
potato-nobody wants to hold it for long’

Again, the usefulness of the quantity theory i:
predicting changes in the price level in the long rul
hittg”s on how stable and predictable the velociry c:
money is over time.

ffisqru 5t*b3e Es Xfe$ssitY?
Exhibit 6 graphs velocity since r96o, measured bof-
as nominal GDP divided by Mr in panel (a) and a:
nominal GDP divided by Mz in panel (b)’ Betwee::
r95o and r98o, Mr velocity increased steadily and ir-

that sense could be considered at least predictabi’.
Mr velocitybounced around duringthe r98os’ Buti;:

tices change slowly over time, and the effects

of these changes on velocity are predictable’
Another factor affecting veiocity depends

on how stable money is as a store of value. Th;

better money serues as a store of value, the morz

money people hold, so the Tower its uelociry. For

example, the introduction of interest-bearinE
checking accounts made money a better store

of value, so people were more wiiling to holc
money in checking accounts and this finar:-
cial innovation reduced velocity’ On the other
hand, when inflation increases unexpectedlt-”
money turns out to be a poorer store of value

People become reluctant to hold money an:
try to exchange it for some asset that retains
its value better. This reduction in people’:
willingness to hoid money during periods cf
high inflation increases the velocity of mone’;
During hyperinflations, workers usualiy ge:
paid daily, boosting velocity even more. Thus.
velacity increases with a rise in the inJlation rar’i

the early r99os, more ar.:
more banks began offe:-
ing money market func=
that inciuded limite:
check-writing privilege:
or what is considere :
Mz. Deposits shiftel
from Mr to M2, whi:-
increased the velocitY :;
Mr. Also in recent Years
more peopie began usir-*

Potential outPut
LRAS

0)

0) 140

‘.
o_

‘t4.0 Real GDP
(triltions of dollars)

,

gone by the end of the period. In that case, a work-

“r’,
uu”t”gu money balance during the pay period is

$r,ooo. If a worker earns the same $5z,ooo per year
but, instead, gets paid $r,ooo weekly, the average
money balance during the week falls to $5oo’ Thus,
the more often workers get paid,other things constant, the

lower their qverqge money balances, so the more active the

money supply and the greater its uelocity. Payment prac-

their ATM and debit cards to pay directiy at grc-
cery stores, drugstores, and a growing number c:
outlets, and this too increased the velocity of l{:
because peopie had less need for walking-arou:-:
money. Mr velocity increased from about 6’o i:’
r993 to over 8,o more recently. Mz veiocity appea:-!
more stable, as you can see by comparing the tru:
paneis in Exhibit 6.

234 PAR’T’ 3 Fiscal and tulonetary Poltcv

i:r a few years, the Fed focused on changes in
soney supply as a target for monetary pollcy

:le short run. Because Mr velocily became so
,,t’31e during the r98os, the Fed in 1987 switched
:- iargeting Mr to targeting Mz. But when Mz
:::ry became volatile in the early r99os, the Fed
‘.:,:nced that money aggregates, including Mz’
*-e no longer be considered reliable guides for
:-.iary policy in the short run. Since 1993, the
.:jon of exchange has been considered more of a

‘;.1’ {:

‘*ri{city of Money

rough guide linking changes in the money supply to

inflation in the long run.
What is the long-run relationship between

increases in the money supply and inflation? Since
the Federal Reserve System was established in r9r3,
the United States has suffered three episodes of
high inflation, and each was preceded and accompa-

nlea Uy sharp increases in the money suppiy’ These
occurred from r9r3 to t9zo, 1939 to t948, and ry67
to r98o.

11ll

(a) Velocity of M1

:960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2008

(b) Velocity of M2

1360 1965 1970 1975 1980 1985 1990 1995 2000 2005 2008
WE 3:::cnic Repoft of the President, January 2009. To compute the latest velocity, go to htto://
r-:!:=;,::ss.sq!&o!l1 find the statistical tables in the appendix then divide nominal GDP by Ml and by M2

LO4 Targets for
Monetary PolicY
In the short run, monetary Pol-
icy affects the economY iargelY
by influencing the interest
rate. In the long run, changes in
the money suPPiY affect the Price
level, though with an uncertain
lag. Should monetary authorities
focus on the interest rates in the
short run or the suPPlY of moneY
in the long run? As we will see,
the Fed lacks the tools to focus on
both at the same time.

eontrasting Polieies
To demonstrate the effects of dif-
ferent policies, we begin with the
money market in equilibrium at
point e in Exhibit 7. The interest
rate is i and the money stock is M,
values the monetary authodties
find appropriate. SuPPose there
is an increase in the demand for
money in the economy, PerhaPs
because of an increase in nominal
GDP. The money demand curve
shifts to the right, from D* to D’*’

When confronted with an
increase in the demand for mone):’
monetary authorities can choose
to do nothing, therebY ailowing
the interest rate to rise, or they can
increase the moneY suPPlY enough
to hold the interest rate constant’
If monetary authorities do nothing,
the quantitY of moneY in the econ-
omy remains at M, but the inter-
est rate rises because the greater
demand for moneY increases the

CHAPTER r6 Monetary iheory and Policy 235