Question

Does a decrease in the money supply cause a change in output, prices, or both?

Short answer

A decrease in money supply could cause both a change in output and prices in the short run. However, in the long run, only prices are affected as output returns to its natural level assuming the economy is flexible.

Step-by-step solution

Understanding the relationship

When the money supply falls, people will have lesser money to spend on goods and services. Therefore, the decrease in money supply leads to a decrease in aggregate demand.

Effects on Output and Prices: Part 1

A decrease in aggregate demand shifts the AD curve to the left in the AD-AS model. In the short run, this results in a lower output as businesses will produce fewer goods and services due to lower demand.

Effects on Output and Prices: Part 2

Along with lower output, companies may lower prices to try to increase demand. Therefore, in the short run, both output and prices can decrease due to a decrease in the money supply.

Long-Term Effects

However, in the long run, output returns to its natural level because prices eventually adjust to the lower level of demand, assuming that the economy is flexible. This means that the effect on output is only temporary, while the effect on prices is more permanent.

Key concepts

Aggregate Demand

Aggregate demand represents the total amount of goods and services demanded in an economy at a specific overall price level and within a given period. It's a crucial component that guides economists in understanding economic activity. When we talk about aggregate demand, it's important to view it as the sum of everyone's spending—consumers, businesses, and the government—as well as net exports.

Aggregate demand can shift due to various factors, such as changes in consumer confidence, investment spending, government policies, and, notably, the money supply.

When the money supply decreases, as posed in the original exercise, people effectively have less money to spend. Hence, aggregate demand decreases, moving the aggregate demand curve to the left on the AD-AS model. This leftward shift illustrates that, at any given price level, the quantity of goods and services demanded has decreased.

AD-AS Model

The AD-AS model stands for the Aggregate Demand - Aggregate Supply model. It’s a fundamental tool that combines aggregate demand and aggregate supply to depict economic equilibrium. By analyzing the interactions between aggregate demand (AD) and aggregate supply (AS) curves, economists can evaluate how economic policies and external factors influence the broader economy.

The downward-sloping aggregate demand curve shows the inverse relationship between the price level and the quantity of goods and services demanded. Conversely, the aggregate supply curve can be upward sloping in the short run but is typically vertical in the long run, reflecting the economy's natural level of output.

When aggregate demand drops due to a lower money supply, the AD curve shifts left. This shift results in a new equilibrium point on the AD-AS graph where output is lower, and if the economy has excess production capacity, prices may also fall.

Short-Run and Long-Run Effects

Understanding the short-run and long-run effects of economic changes on output and prices is key to grasping broader economic dynamics. In the short run, a decrease in the money supply will reduce aggregate demand, leading to lower output and, often, lower prices as businesses adjust to maintain sales.

This short-run perspective highlights the immediate impact of reduced spending power, characterized by underutilized resources and economic slack. Firms are likely to respond by cutting back on production and possibly reducing prices.

In the long run, however, the economy is expected to adjust. Prices and wages are assumed to be flexible enough to bring the actual output back to the potential output, which is determined by factors like technology, labor, and capital. Over time, the lower prices and wages help increase aggregate demand, guiding the economy back to its full employment level of output. This is why, while short-run effects are pronounced in terms of output and price changes, the long-run scenario sees output returning to its natural, sustainable level, with prices remaining adjusted as per the shift in demand.