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Question from Past Macroeconomics Qualifying Exam (Fall, 2005 - Question one) at George Mason UniversityEdit

Different macroeconomic models of economic fluctuations predict that an expansionary monetary policy affects output in different ways.

  1. Select a model in which an expansionary monetary policy leads to an increase in real output. Carefully explain the mechanism through which this occurs.
  2. Select a model in which an expansionary monetary policy leads to a decline in real output. Clearly explain the mechanism through which this occurs.
  3. Select a model in which an expansionary monetary policy leads to no change in real output. Carefully explain the mechanism through which this occurs.
  4. Which of these three models has had more empirical success? Explain.


1. In the Hicksian IS-LM model (as in many models), any expansion of the money supply requires that a money-market equilibrium (i.e., the condition that quantity supplied equals quantity demanded) be restored. Hicks says the money supply is determined exogenously, so the restoration of equilibrium must be accomplished via an increase in money demand. Money demand is determined endogenously, by income and the interest rate. An increase in income would raise the demand for money for use in transactions (assuming more or larger transactions when there is higher income) or for precautionary purposes (assuming that people wish to have precautionary cash holdings in proportion to their income). A reduction in the interest rate would raise the demand for speculative money balances (as more people expect interest rates to rise when rates are lower than usual, and these people therefore will sell bonds to hold cash). So some combination of an increase in income and/or a reduction in interest rates is necessary to maintain money-market equilibrium in the event of an expansion in the money supply.

The precise combination will be determined by the goods market. Goods-market equilibrium is determined entirely on the demand side, where planned expenditures must equal actual expenditures. Given the assumption that Investment expenditures are inversely related to the interest rate (because more investment opportunities are exploited when the opportunity cost of so doing, represented by the interest rate, is lower), goods-market equilibrium holds when higher output is associated with a lower interest rate.

Therefore, we know that the necessary equilibriating increase in money demand cannot be achieved purely through an reduction in the interest rate, because such a reduction would cause higher output in the goods market, which would lead to a further reduction in the interest, resulting in an overcorrection where the quantity of money demanded would come to exceed the quantity supplied. Instead, the increase in money demand must be achieved via the particular combination of lower interest rates and higher output that is consonant with goods-market equilibrium.

2. In the Austrian model of the business cycle expansionary monetary policy leads a reduction in output in the long term. Lower interest rates due to monetary expansion lead to more investment into new early stages of production and more consumption, which results in investment into the late stages of production. The middle stages of production will in the meantime be under maintained. Since the economy’s level of equilibrium output is limited by the production possibility frontier both investment and consumption pull the equilibrium level of output as if in a tug-of-war of off the production possibility frontier towards a new virtual level of output. Since the low interest rate and higher level of investment cannot be sustained in the long run however, because of the unsustainably low rate of savings, the economy is pulled back onto the production possibility frontier and beyond that into a bust. The investments into new stages of production become unprofitable at a new higher interest rate, and consumers shift consumption to the future resulting in the late stages of production becoming unprofitable. The under maintained middle stages of production furthermore reduce the ability to sustain current levels of output.

In the Austrian model of the business cycle expansionary monetary policy leads to a reduction in overall output.

This may be a stretch, but if there is an expansionary monetary policy, but one where anticipated changes are more than actual increases in money supply, Monetarist Theory would also predict lower real output.

3. In the classic model and in Real Business Cycle Theory expansonary monetary policy doesn't have any effects, because money is neutral. It will merely lead to an increase in nominal prices, but won't affect real variables.

4. Keynes' model of aggregate output has certainly had the most empirical success. The existence of a central bank indicates this, because it wouldn't be justified neither under the classical nor the austrian model, because its assumed effect would either be non-existent or negative. The same holds for fiscal policy.

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