Home > Macro, Monetary Policy > Monetary policy in the short and medium run

Monetary policy in the short and medium run

There is a very important concept in monetary policy called the neutrality of money. This means that although in the short run, you can use monetary policy – ie the rate at which you grow the money supply – as a tool to influence output and unemployment, monetary policy will have no effect on output and unemployment in the medium run. The only think that the rate of money growth will influence in the medium run is inflation, and if you try to stimulate output for too long through a fast rate of money growth, you will just get punished with a high level of inflation.

This rests on the idea that in the medium run, the economy will return to a natural level of output and natural rate of unemployment. The natural level of output is determined by the supply conditions in the economy, but more realistically, if we are in an economy that is growing over time (its supply potential is steadily increasing) then we will have a natural rate of output growth. The relationship between output growth and unemployment is given in Okun’s Law, and the relationship between unemployment and inflation is given in the Phillips Curve.

If the economy always returns to a natural rate of output growth, then assuming the population growth stays constant, the economy will always return to a natural rate of unemployment. This is where you will get to in the medium run.

However, inflation is not only influenced by the rate of unemployment, but also by expectations of inflation, and here is where money growth influences inflation. When agents in the economy realise that the money supply is increasing faster, and inflation is rising, they will reflect this in their wage bargaining agreements, and it will push inflation up. The rate of money growth is approximately related to inflation and the rate of output growth through the expression $\pi = g_m - g_y$ .

So if in the medium run we know that the growth of output will be $\bar {g_y}$ then in the medium run inflation will be $\pi = g_m - \bar {g_y}$, ie it depends on how much bigger $g_m$ is than $\bar {g_y}$.

This is why money is described as being neutral in the medium run – well, it is neutral in terms of output and unemployment, it is certainly not neutral in terms of inflation!

This is also where the famous Milton Friedman quote “inflation is always and everywhere a monetary phenomenon” comes from – it is saying that in the medium run, inflation solely depends on the rate of money growth, and so if you have a tight grip on your monetary policy you shouldn’t need to worry about inflation getting out of control (in theory anyway).

In the short run, monetary policy does have an effect on output and unemployment – you can trace this easily through using the ISLM model. The ISLM model is a ‘static’ economy model not a model for a growing economy, so you have to use a bit of imagination. When the economy is growing (output is growing) then raising the rate of money growth above the rate of output growth is like raising the money supply in the static ISLM model, which means shifting the LM curve down. This will lower the equilibrium rate of interest, and when interest rates are lower, firms invest more and output rises. In a growing economy this means output rises more than the natural growth rate.

Alternatively, reducing the rate of money growth below the rate of output growth is like cutting the money supply in the static ISLM model, which means shifting the LM curve up. This will raise the equilibrium rate of interest, and when interest rates are higher, firms invest less and output falls. In a growing economy, when the ISLM model tells you that output is falling, it may not actually be falling, it means it is growing below the natural growth rate. So if the natural growth rate of output was 2.5% per year, then a growth of output of 1.8% would show up as a fall of output below the natural level, in the ISLM model. Hope that is not too confusing!

You can read more on this in the sections on the short and medium run effects of a monetary expansion and monetary contraction.