About Short run money and long run money???

Question

In the short-run money can influence real output and unemployment. However, in the long run, money is neutral to the real factors in the economy and just influences price level. Explain the differences in the short-run and long run and how do you explain the neutrality of money in the long run.

Answer 1

Difference between shortrun and longrun is that while in the shortrun a change in money supplywill not be able to work out fully through to effect money prices, noimnal interest rates and nominal wages because of downward stickiness of wages, money illusion etc and thus the real variables get affected, in the longrun a change in money supply can fully work out its effects through all monetary/ nominal variables like prices and wages and interest rates and there will be little money illusion, the real variables will remain unaffected. Neutrality of money is the idea that a change in the stock of money affects only nominal variables in the economy such as prices, wages and exchange rates, having no effect on real variables like GDP, employment, and consumption. It is an important idea in classical economics and is related to the classical dichotomy. Money neutrality implies that the central bank cannot affect the real economy (eg, the number of jobs, the size of GDP, the amount of investment) by printing money. Any increase in the supply of money would be immediately offset by an equal rise in prices and wages.

Many economists argue that money neutrality is a good approximation for how the economy behaves over long periods of time, but in the short run, consider it likely that money might affect output. One argument is that prices and especially wages are 'sticky', and cannot be adjusted immediately to an unexpected change in the money supply. An alternative explanation for real economic effects from money supply changes is not that people can't change prices (because of menu costs, etc) but that they don't realize that they should. The bounded rationality approach suggests that small contractions in the money supply are not taken into account when individuals sell their houses or look for work, and that they will therefore spend longer searching for a completed contract than without the monetary contraction. Furthermore, the floor on nominal wages changes imposed by most companies is observed to be zero; an arbitrary number by the theory of money's neutrality but a very real psychological threshold. The New Keynesian research program in particular emphasizes models in which money is not neutral, and therefore monetary policy can affect the real economy.

Superneutrality of money is a stronger property than neutrality of money. If money is superneutral, then not only the level of the money supply, but also the rate of money supply growth, has no effect on real variables. Both the money supply and its growth rate affect nominal variables such as the price level and inflation rate in this case.

To summarize: An economic theory that states that changes in the aggregate money supply only affect nominal variables, rather than real variables; therefore, an increase in the money supply would increase all prices and wages proportionately, but have no effect on real economic output (GDP), unemployment levels, or real prices (prices measured against a base index). The neutrality of money is based on the idea that changing the money supply will not change the aggregate supply and demand of goods, technology or services. It was a cornerstone of classical economic thought, but modern-day evidence suggests that neutrality of money does not fully apply in financial markets.  The neutrality of money is considered a plausible scenario over long-term economic cycles, but not over short time periods. In the short term, changes in the money supply seem to affect real variables like GDP and employment levels, mainly because of price stickiness and imperfect information flow in the markets.  Central banks like the Federal Reserve monitor the money supply closely, and step in (through open market operations) to change the money supply when conditions deem it necessary. Their actions indicate that short-term money supply changes can and do affect real economic variables. Economists generally feel that certain elements like wages have stickiness to them; employers can raise wages but lowering them is nearly impossible in a practical sense. Also, companies are reluctant to make minor changes to prices just because of a slight change in the money supply. Effects like this undermine the conclusions that can be reached from short-term analysis of the neutrality of money.