Question

Assuming prices are flexible in the long-run, and assuming the velocity of money is

constant, what will be the long-run effect of expansionary monetary policy

undertaken by the Federal Reserve? What about the effect of contractionary

monetary policy?

Answer 1

We know in long run, economy is at full employment output

in simple words real GDP in long run is equal to potential output(real GDP is vertical)

and velocity is assumed to be constant

thus according to Quantity theory of money

MV=PY

Thus change in Y=change in Velocity=0

Thus expansionary monetary policy will have direct effect on price and will lead to higher price. Thus expansionary monetary policy will lead to inflation

and contractionary monetary policy leads to deflation or decrease in prices