Question

1. According to classical macroeconomic theory, money supply shocks are “neutral.”

a.Explain what this means.

b.Based on that theory, how would a 5% increase in a nation’s money supply affect its real 
wage rate (W/P), all else equal (up, down, or no change, and by how much)? 


c. According to the quantity theory of money, how would a 5% increase in the money supply 
affect the price of goods and services (P), all else equal (up, down, or no change, and by 
how much)? 


d. To be consistent with both theories, what would have to happen to the nominal wage rate 
(W)? Explain. 


Answer 1

a. Money Supply Shocks are neutral means that any change in the quantity of money supplied by the economy will only lead to change in the nominal variables of the economy and not the real variables.Thus, money is neutral.

b. A 5 per cent increase in nation's money supply will keep the real wage rate of the economy constant. This is because money only impacts nominal variable and not real variables.

c. It will lead to equal increase in the prices of goods and services. Thus, with the increase in money supply by 5 per cent, the prices of goods and services will also increase by 5 per cent.

d. To be consistent with the above theories, the nominal wage must have risen by 5 per cent which will keep the real wages.