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Using IS-LM and AS-AD models of the economy, show that monetary policy is effective in the...

Using IS-LM and AS-AD models of the economy, show that monetary policy is effective in the short run but neutral in the long run.

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Answer #1

The expansionary monetary policy shifts the LM curve to the right. Due to this, interest rates lower in the economy.

The lower interest rates lead to rise in consumer spending and investment in the economy.

This shifts the AD curve in the economy.

Now, the shift in AD curve in the short run leads to its intersection with the aggregate supply curve at the higher price level.

Over time, due to higher price level, people will start demanding more wages. Businesses will start laying off workers due to this. This will lead to decline in the output levels of the firms.

Thus, the AS curve will shift backwards over time.

The above mentioned events will also shift the IS curve downwards.

Thus, monetary policy was effective in the short run as the output increased. However, it becomes ineffective in the long run.

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