I’m struggling on a question and I really don’t understand the answer with the definition I read from money neutrality:
in the Short run, will an increase in the money supply increase the price level and real output?
correct answer: both will increase in the short run
I am disturbed as I tought that the money neutrality was stating that “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)” (Investopedia).
Therefore, will would an increase in the money supply increase real output? Is there something I misunderstood ?
In the short run, an increase in the money supply will increase aggregate demand: the demand curve shifts to the right, so the new (temporary) equilibrium point is up and to the right along the (unchanged) supply curve: higher prices and higher output.
In the long run, the economy will return to full employment: the aggregate supply curve will shift to the left, and the new (permanent) equilibrium point is up and to the left: higher prices, and output back at full potential GDP.
GDP has 2 versions, the Nominal GDP and Real GDP. Assume GDP is calculated as Price x Quantity (which is fairly close to the proffesional calculation method).
At t=0, P=50 and Q=20 so Nominal and Real GDP are the same, 1000.
At t=1, P=60 and Q=20. Nominal GDP is 60x20=1200, but Real GDP is calculated using constant prices. In this case Real GDP is 50x20=1000
Has the country grown? No, because real GDP hasn’t. Real GDP is a real variable because it counts for phisical change (Q), and Nominal GDP is a nominal variable because it uses current prices.
From observation, many economists has concluded that money expansion just increases prices, but not quantities. This means that no real wealth is created, just inflated prices. So how wealth is created? Through work. But this work needs a fuel: money. The conclusion is that the exact or adequate amount of money in the economy permits the real growth, but indirectly. In other words, production grows slow, if money grows much faster than production you just create a demand pression over supply and prices receives the whole impact in the short run, however, in the long run, real output (production) will increase due that initial money expansion. The idea is to grow in order, without creating inflation, because it is just an unnecessary pain.
