Monetary policy in the long run | AP Macro Long-run consequences of stabilization policy

In the short run, monetary policy stimulates the economy as fiscal policy does although exactly how this occurs is not the same. Monetary policy changes the money supply, which changes interest rates. This shifts $A D$ , to the right if the money supply is higher (lower interest rates) and to the left if the money supply is lower (higher interest rates).

In the long run, the self-adjustment mechanism of all wages and prices fully adjusting always brings the economy back to full employment. So the economy returns to the initial level of GDP and unemployment for any shift in $A D$ or any temporary supply shock to $S R A S$ . Because monetary policy is one of those $A D$ shifters, we end up with our long run result rather efficiently.

Definitions

Neutrality of money: In the long run, changes in the money supply affect the price level but do not affect real output.

This is a direct outcome of a vertical $L R A S$ and $L R P C$ , due to prices fully adjusting and matching expectations in the long run. Money can affect nominal variables, but not real ones.

Put another way, monetary factors are not shifters of either curve. Thus monetary policy can be used to counter a recession and possibly a supply shock or stagflation, but it cannot be used to generate long run growth.

Combining fiscal and monetary policy

So far we have looked at fiscal and monetary policy one at a time. A combination of the two may be used to restore full employment in a recessionary or inflationary gap, and the combined effect comes from adding the two stories together.

Expansionary fiscal policy shifts $A D$ to the right, and the added government borrowing pushes interest rates up. Expansionary monetary policy also shifts $A D$ to the right, but it pushes interest rates down. So when the two policies point in the same direction, the effect on $A D$ is known and the effect on interest rates is not. When they point in opposite directions, the effect on interest rates is known and the effect on $A D$ is not.

Fiscal policy	Monetary policy	$A D$	Real output and price level	Interest rate
Expansionary	Expansionary	$\to$	$↑$	Unknown
Contractionary	Contractionary	$\leftarrow$	$↓$	Unknown
Expansionary	Contractionary	Unknown	Unknown	$↑$
Contractionary	Expansionary	Unknown	Unknown	$↓$

So to close a recessionary gap, the government and the central bank can both choose expansionary policy. In an inflationary gap, they can both choose contractionary policy.

Monetary overshooting

Recognition and decision lags can be relatively fast for monetary policy. FOMC meetings can be held outside of the regular schedule in order to respond more quickly to a crisis.

However, implementation lag is slower than fiscal policy. This means that monetary policy will overshoot, or push the economy past full employment in the short run. In the chart below, this is represented by a movement from point $1$ to point $2$ .

$AD$ shifts past $LRAS$ due to monetary policy, so the transition to long run leads to even higher inflation. — Monetary policy overshooting

The long run adjustment from point $2$ is no different than any other. Inflation expectations will rise, leading $S R A S$ to shift left and to an increase in the price level. The economy settles into a new long run equilibrium at point $3$ . Monetary policy does close the recessionary gap in the long run, but can be considered to cause additional inflation due to implementation lag.

Money is neutral but monetary policy by itself can be expected to cause small amounts of extra inflation.

The long run neutrality of money is reinforced by a final important concept connecting the money supply to spending in the economy.

Quantity theory of money

The impact of money supply changes on the price level can even be measured in a relatively straightforward way. That requires an equation known as the quantity theory of money.

$M \times V = P \times Y$

Three of the pieces of this equation are things we have seen before:

M = money supply
P = price level (for example the GDP deflator)
Y = real GDP

And one we have not seen before:

V = velocity of money

The velocity of money is the average number of times a dollar is spent in a year. For our purposes, we can treat velocity as stable. If it is not constant, it is close enough to constant in the long run.

The left side of this equation is $M \times V$ , which is total spending in the entire economy in a year. The right hand side is $P \times Y$ , which is the value of all goods purchased in the economy in a given year. In other words, nominal GDP. So the quantity theory says that the flow of dollars in the economy must enable the purchase of all goods that were produced.

Velocity being constant means that if the money supply grows faster than real output then the price level must rise. So not only does money not affect real production in the long run, the only long run outcome of increasing the money supply is inflation.

This is why inflation is described as a monetary phenomenon. Sustained inflation results from increasing the money supply at too rapid of a rate for a long period of time, and sustained deflation from decreasing it too rapidly. A single increase in the money supply raises the price level once. It takes continued money growth beyond real GDP growth to keep prices rising year after year.

For AP Macroeconomics, this is a conceptual framework and an identity. You will not have to re-arrange this, only complete relatively simple calculations. You may be expected to use the fact that if velocity is nearly constant,

$Inflation = Money supply growth - Real GDP growth .$

To make it as clear as possible, here’s a quick example of the highest math difficulty to expect.

Q: If the money supply increases by 5%, and real GDP is the same as last year. What does the quantity theory of money predict inflation will be?

The same as the previous year
0%
5%
3%
-5%

Answer below.

(spoiler)

c. 5%, What the quantity theory tells us is that money supply growth beyond the rate of GDP growth must lead to inflation. So with constant real GDP, inflation is the same as the growth rate of money.

Finally, this result of the quantity theory makes it clear what we would expect as a side-effect of printing money to pay for government budget deficits rather that using tax revenue. Printing money that is not a response to real GDP growth only leads to inflation.

Completing a back of the envelope calculation for the US in 2025, government spending was roughly 31% of M2 and real GDP growth was just short of 2%. So if the government raised no tax revenue at all and only printed money to fund current expenditures, the quantity theory suggests that would cause 31%-2%=29% inflation.

Printing money to pay for government budget deficits is a significant contributor to historical episodes of hyperinflation. Inflation expectations rise which leads $V$ to increase. If $M$ and $V$ both increase, $P$ rises. This lowers the value of any tax revenue, so the government has to print even more money to make purchases or fund desired programs. The additional money printing causes $V$ to rise even further. The cycle continues and inflation rises far beyond its usual level.

Monetary policy and the long run

Short run: money supply changes shift interest rates, which shift $A D$ (higher $M$ → lower rates → $A D$ right; lower $M$ → higher rates → $A D$ left)
Long run: full wage/price adjustment returns economy to original GDP/unemployment regardless of $A D$ shifts or supply shocks
Neutrality of money: in the long run, money supply changes affect price level only, not real output (vertical $L R A S$ / $L R P C$ , monetary factors don’t shift these curves)
Monetary policy can fight recessions/supply shocks short-run, but cannot generate long-run growth

Combining fiscal and monetary policy

Effects combine; same-direction policies (both expansionary or both contractionary) → known effect on $A D$ /output/prices, unknown effect on interest rates
Opposite-direction policies → known effect on interest rates, unknown effect on $A D$ /output/prices
Expansionary fiscal raises interest rates (borrowing); expansionary monetary lowers them
To close recessionary gap: both expansionary; to close inflationary gap: both contractionary

Monetary overshooting

Monetary policy has fast recognition/decision lags (e.g., emergency FOMC meetings) but slow implementation lag
This causes $A D$ to overshoot $L R A S$ , pushing economy temporarily past full employment
Long-run adjustment: rising inflation expectations shift $S R A S$ left, settling at higher price level (new equilibrium)
Net effect: monetary policy closes gaps but tends to cause extra inflation due to overshooting

Quantity theory of money

Formula: $M \times V = P \times Y$
- $M$ = money supply, $V$ = velocity of money (avg. times a dollar spent/year, treated as stable), $P$ = price level, $Y$ = real GDP
Left side = total spending; right side = nominal GDP; equation is an identity
Key simplified relationship (constant $V$ ): $Inflation = Money supply growth - Real GDP growth$
Sustained inflation/deflation = monetary phenomenon from money growth persistently outpacing/underpacing real GDP growth
Printing money to fund deficits (not tied to real GDP growth) causes inflation; can spiral into hyperinflation as rising inflation expectations raise $V$ , forcing more printing and further price increases