Question

Suppose that the federal reserve attempts to keep the price level constant over time. Show in the money-market diagram how they would need to change the nominal money-supply in the long-run if labor productivity was to increase.

Answer 1

An increase in labor productivity will decrease price level in long run, since long-run and short-run aggregate supply curves will both shift rightward, increasing real GDP and potential GDP while decreasing price level. To keep price level unchanged, Fed has to lower money supply, which will increase interest rate and decrease aggregate demand, thereby lowering price level.

In following graph, MD0 and MS0 are initial money demand and money supply curves intersecting at point A with initial interest rate r0 and quantity of money M0. As Fed decreases money supply, MS0 shifts left to MS1, intersecting MD0 at point B with higher interest rate r1 and lower quantity of money M1.