Question

a) Discuss monetary policy and fiscal policy by comparing and contrasting their effects in the short run and in the long...


a) Discuss monetary policy and fiscal policy by comparing and contrasting their effects in the short run and in the long run. b) Why do we say that monetary policy is neutral in the long run? If so, why is it being used and considered as useful? c) Can we say that fiscal policy is neutral as well?

Answer

(a)

Monetary Policy

An expansionary monetary policy causes the output to rise, the price level to rise, and the interest rates fall in the short run. Whereas in the long run, the output remains unchanged, prices rise and the interest rates remain unchanged.

This can be explained through the following diagram.

Economics homework question answer, step 1, image 1

In the IS-LM diagram, an increase in money supply causes the LM curve to shift left from LM0 to LM1. The IS remaining unchanged, the equilibrium shifts to A1 with a higher level of output and lower interest rates. As a result, the AD curve in the AD-AS diagram shifts right, causing the prices to rise from P0 to P1. The new short-run equilibrium is at A1, with increased production Y1, higher price P1, and a lower interest rate i1.

In the long run, the price level is greater than that expected, thus the expected price level rises as well. The workers start demanding higher nominal wages, as a result of which firms raise prices. This causes the AS curve to shift upwards from AS1 to AS2 and the equilibrium moves from A1 to A2 with prices higher than before (P2).

When we look at the IS-LM Model again, we can see that when the price level rises, the real money supply contracts, and the LM curve changes back upwards. The interest rate returns to its original level (i0), and the level of output returns to its original level (Yn). 
Overall, monetary expansion lowers the interest rate, raises output, and raises the price level in the near run. In the long run, the interest rate returns to its starting level, output levels return to their initial levels, and pricing levels return to their initial levels.

 

Fiscal Policy

An expansionary fiscal policy causes the output to rise, the price level to rise, and the interest rates rise in the short run. Whereas in the long run, the output remains unchanged, prices and interest rates rise.

This can be explained through the following diagram.

Economics homework question answer, step 2, image 1

When we first look at the IS-LM graph, we can see how an increase in government spending causes the IS curve to shift to the right, from IS0 to IS1. The fiscal expansion leads the AD Curve to shift to the right, from AD0 to AD1, on the AS-AD diagram. The new equilibrium features a higher level of output, Y1, as well as a higher level of price, P1. This higher price level partially compensates the increase in output by reducing the real money supply (M/P), shifting the LM Curve northward from LM0 to LM1. The new (short-run) equilibrium is at A1, with increased production Y1, higher price P1, and higher interest rate i1.

The price level has risen above the expected price level, Pe, in the medium run, and so the expected price level has risen as well. This raises the price level further higher, lowering the real money supply (M/P) and shifting the LM Curve even higher, to LM2. The output level falls back to its normal level, Yn, and the interest rate rises to i2. The AS Curve shifts up as the price level rises, resulting in A2 as the medium term equilibrium, with output at the initial natural level (Yn) and the price level rising to P2.

Therefore,

 

The table below shows the effects of fiscal and monetary policy in short run and long run (or medium run).

Economics homework question answer, step 3, image 1

(b)In the long run, monetary policy is neutral, since the nominal money supply has no influence on output or interest rates. The corresponding increase in the price level is totally represented in the growth in the nominal money supply. The position of the IS curve and the natural level of output define the interest rate (which is determined by the position of the AS curve). Because the IS curve does not change, the interest rate (and thus the level of investment) does not change, and thus the level of production does not vary. As a result, monetary policy is ineffective in the medium term.

Despite money's medium-term neutrality, monetary policy can be beneficial in the short term. The LM curve shifts down, while the AD curve shifts to the right as a result of monetary expansion. As the interest rate falls, output rises as a result of higher investment. In conclusion, monetary policy can be beneficial in the short run since it lowers interest rates and boosts output. When used correctly, monetary policy can hasten the economy's restoration to its natural level of output after it has fallen below it.

(c) Both fiscal and monetary policy have no influence on the natural level of output in the long run, but price levels rise in both circumstances. In contrast to expansionary monetary policy, expansionary fiscal policy leads to an increase in the medium-term interest rate. The amount of output (Yn), consumption (C), and taxes (T) are all the same as previously (T). As a result, the rise in government spending (G) is countered by the drop in investment (I) produced by the interest rate hike.

Economics homework question answer, step 5, image 1

As a result, fiscal policy is not neutral because it alters the composition of aggregate demand on the products market over time. A rise in G leads to a drop in investment. A drop in G, on the other hand, resulted in an increase in investment.

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