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Explain the concept “neutrality of money”. Use the money market diagram and the AS-AD diagram to...

Explain the concept “neutrality of money”. Use the money market diagram and the AS-AD diagram to explain, starting with a monetary expansion.

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Answer #1

The economy is initially at e equilibrium. Now there is a monetary expansion that shifts the AD curve rightward to AD' new short run equilibrium is reached at e'where price level has increased to P'and output has increased to Y'.

In the long run wages will adjust and increase because workers are employed more than full employment level. This increase in cost of production shifts the AS curve leftward to AS'. Long run equilibrium is reached at e'' where output returns back to Y and price level increases further to P''.

Thus in long run monetary policy has no effect on output which is referred to as neutrality of money.

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