There are two forces that cause the economy to grow. One is real, the other is a
ID: 1127662 • Letter: T
Question
There are two forces that cause the economy to grow. One is real, the other is an illusion. The real force—entrepreneurial innovation and creativity—comes naturally as long as government policies do not drive it away. The artificial force is easy money. An increased supply of money, by creating an illusion of wealth, can increase spending in the short run, but this eventually turns into inflation. Printing money cannot possibly create wealth; if it could, counterfeiting would be legal. Brian Wesbury, “Economic Rehab,” The Wall Street Journal, June 7, 2006, p. A14. Does this quote illustrate the short-run versus the long-run aspects of monetary policy? Why or why not?
Explanation / Answer
Yes it definitely does. While the analysis seems to be suggesting that printing money or seigneorage to finance the budget deficit or to increase the supply of money, creates inflation in the long run there are some real effects in the short run. If we assume wages and prices to be fixed in the short run and variable in the long run, then the supply of money will be the deciding factor in increasing the real GDP in the short run. In such a case though there is an Illusion of money, the illusion works and real GDP is increased in the short run. But this is not sustainable because as the long run is approached the prices and wages are increased so that the increase in real GDP is limited only to its full employment level.
However the full employment level of output can be increased by Innovation and productivity which are enhanced by technological progress. Supply of money can increase output only in cases when there is a recessionary gap and full employment level of output is not yet achieved. But innovation entrepreneurship technology and productivity are factors that can increase the level of potential output which is a factor to be affecting the real GDP in the long run.
Therefore monetary policy is effective in the short run but ineffective in the long run.