Basic References: Hall and Taylor, Chapter 8; Study Guide, Chapter 8. In previous chapters, HT develop two of the components of their macro model: the "long-run growth model" for the determination of potential GDP in period T, Y*(T); and the IS-LM model for the determination of actual GDP in period T, Y(T). In this chapter HT develop the third and last component of their macro model: the "Phillips Curve" describing the way in which the general price level adjusts over time in response to discrepancies between potential and actual GDP in each period T. Before detailing the nature of this price adjustment process, we need to introduce a more comprehensive definition of equilibrium than the notion of short-run equilibrium introduced in HT7. A. A MORE COMPREHENSIVE DEFINITION OF EQUILIBRIUM Recall from HT7 that an economy is said to be in a #short-run equilibrium# if both the money market and the product market for the economy are in equilibrium. Equivalently, by construction of the IS and LM curves, an economy is in a short-run equilibrium if and only if its current Y and R levels constitute an intersection point of its IS and LM curves. For this reason, a "short-run equilibrium" is often referred to as an "IS-LM equilibrium." By construction, the AD curve for an economy is derived from the locus of intersection points of the economy's IS and LM curves. Consequently, yet another way to characterize short-run equilibrium for an economy is to say that it is on its AD curve. Note that the fact an economy is in a short-run equilibrium say nothing about whether its labor market is in equilibrium. In particular, being in a short-run equilibrium gives no guarantee that actual employment N is equal to potential (full) employment N*, or equivalently, that actual GDP Y is equal to potential GDP Y*. For the complete HT model, we need a more comprehensive definition of equilibrium, "internal balance," that also takes the labor market into consideration. [Although HT make extensive implicit use of the concept of internal balance, for some reason they never refer to it by its conventional name.] #Internal Balance#: An economy is said to be in internal balance if #all# of its domestic markets (money, product, #and# labor) are in equilibrium. In particular, then, an economy is in internal balance if two conditions hold: (i) it is in a short-run equilibrium; and (ii) actual GDP is equal to potential GDP. B. THE TRADITIONAL PHILLIPS CURVE AND PRICE ADJUSTMENT In traditional Keynesian models in widespread use up through the early nineteen seventies, a commonly maintained assumption was that the price level P(T) for period T would not change immediately if firms found themselves producing above or below the potential GDP level Y*(T). Rather, it was assumed that the existence of a gap in period T between potential and actual GDP resulted in some change in the price level in the following period T+1 at the earliest. In particular, it was assumed that the inflation rate from period T to T+1 was positively correlated with the GDP gap in period T for each period T. Such a relation between the inflation rate and the GDP gap is referred to as a #Phillips Curve# in honor of one of the first economists to popularize the relation, in a 1957 #Economica# article. A simple linear algebraic form for the traditional Phillips Curve is as follows: #A Simple Linear Specification for the Traditional Phillips Curve#: Y(T)- Y*(T) (8.1) INF(T,T+1) = f [ ------------- ] , Y*(T) where P(T+1) - P(T) INF(T,T+1) = --------------- = inflation rate P(T) from T to T+1 ; Y(T)- Y*(T) -------------- = GDP gap in period T ; Y*(T) f = positive exogenously given coefficient multiplying the GDP gap which reflects the responsiveness of the inflation rate to changes in the GDP gap. Note that, by manipulating terms, relation (8.1) determines the price level P(T+1) for period T+1 as a function of the period T price level P(T), the period T GDP level Y(T), and the period T potential GDP level Y*(T): Y(T)- Y*(T) (8.2) P(T+1) = P(T) + P(T) f [-------------] . Y*(T) Consequently, once a relation such as (8.1) is appended to the IS-LM model developed in HT7, augmented by labor market relations for the determination of Y*(T), one has a way of determining the movement over time of P(T) as well as the movement over time of Y(T), R(T), and other endogenous variables such as aggregate household consumption C(T). The basic underlying motivation for the Phillips Curve (8.1) was a key empirical regularity, known as "Okun's Law," that still holds today. C. OKUN'S LAW It is a well-established empirical fact that GDP and unemployment are negatively correlated over time, in the sense that periods of high GDP correspond to periods of low unemployment and conversely. [See HT Chapter 1, figures 1-3 and 1-5.] However, as briefly discussed by HT in Chapter 3, it is also an empirical fact that the magnitude of this negative correlation tends to be fairly #constant# over time. In particular, for each percentage point that the unemployment rate U(T) is #above# the natural unemployment rate U*(T), real GDP Y(T) tends to be about 3 percent #below# potential real GDP Y*(T). [See HT Chapter 3, figure 3-5.] This empirical regularity is known as Okun's Law in honor of the economist (Arthur Okun) who first pointed it out. In algebraic terms, Okun's Law takes the following form: #Algebraic Form of Okun's Law#: Y(T) - Y*(T) (8.3) ---------------- = -3.0 [U(T) - U*(T)] , Y*(T) GDP gap discrepancy between actual in period T and natural rates of unemployment in period T Relation (8.3) predicts that a #3 percent decline# in Y(T) will be associated with only about a #1 percent increase# in the unemployment rate U(T). Why should this be so? Many economists, including HT, answer that it reflects the tendency of firms to engage in hedging behavior in response to demand shocks. For example, in response to an unfavorable demand side shock (a decrease in Y^D), firms tend to hedge against the possibility that the negative shock is transient by keeping on workers they don't actually need and demanding less work effort from their workers per hour. Thus, measured productivity (average output per paid work hour) declines along with output Y as firms try to bring Y down in line with the lower Y^D, but the percentage increase in unemployment (laid off or fired workers) is less in magnitude than the percentage decline in Y---in particular, unemployment increases by only about 1 percent in response to a 3 percent decline in Y. A similar story can be told in reverse for favorable demand side shocks. In this way, firms keep up worker morale by providing increased job security, and they also avoid some of the transactions costs associated with the hiring and firing of workers. Of course, if demand shocks persist, most firms ultimately will resort to changes in their employment levels (firing and hiring) to bring these levels in line with output levels. D. RELATION BETWEEN OKUN'S LAW AND THE TRADITIONAL PHILLIPS CURVE [See HT Figure 8-4.] Consider an economy in internal balance in some period T, with an aggregate consumption function given by C = a + b[1-t]Y. Suppose consumer tastes suddenly change---in particular, suppose the coefficient "a" in the consumption function suddenly decreases, implying that households demand fewer goods and services at each given level of Y. In terms of the IS-LM model developed in HT7, the economy's IS curve will shift down in period T in response to this change in the consumption function. Assuming that short-run equilibrium is quickly restored---in particular, that firms act to keep their short-run production levels in line with their demands so that product market equilibrium is retained---actual GDP Y(T) will then decrease to some lower level Y(T)'; for the intersection of the IS and LM curves will now occur at a point where Y and R are both lower. Note that this decrease in Y(T) in response to the sudden period T change in the consumption function coefficient "a" occurs for any value of the current price level P(T), implying that the AD Curve for period T is shifted #downward#. On the other hand, period T potential GDP is unaffected by the change in the consumption function coefficient. Consequently, a negative GDP gap opens up at the current price level P(T), i.e., Y(T) falls below Y*(T). By Okun's Law, the opening up of this negative GDP gap results in an unemployment rate U(T) that is #higher# than the natural unemployment rate U*(T) as firms start to decrease their employment levels in response to decreased demand for their goods and services. Assuming the unfavorable demand shock persists (so that the AD curve is permanently shifted downwards), these conditions ultimately lead to falling wage rates and also to a fall in the prices charged to household for final goods and services as consumption demand for goods and services weakens in response to the fall in Y. This commonly observed sequence of events, from the opening up of a negative (or positive) GDP gap to a fall (or rise) in the prices for final goods and services, is precisely what is captured by the traditional Phillips Curve (8.1). E. THE EXPECTATIONS-AUGMENTED PHILLIPS CURVE [See HT figure (8-5).] Okun's Law and the traditional Phillips Curve (8.1) together predict a #negative# correlation between the inflation rate INF(T,T+1) and the unemployment rate U(T). This prediction seemed to fit U.S. data and policy experience fairly well during the nineteen fifties and sixties. However, in the mid-nineteen seventies things started to go haywire. Specifically, as can be seen from figures 3-1 and 3-4 in HT Chapter 3, Chapter 3, the inflation rate and the unemployment rate exhibited a #positive correlation# in the nineteen seventies, in the sense that they tended to #increase together#---a phenomenon labelled "stagflation." By the end of the nineteen seventies (1979=the second oil price shock), the inflation rate had soared to historically unprecedented heights (over 12 percent) while at the same time the unemployment rate appeared to be trending upwards. However, this was followed, in 1982, by a sudden #drop# in the inflation rate and a huge #increase# in unemployment---the traditional negative correlation had reappeared. Numerous researchers subsequently attempted various fix-ups of the basic Phillips curve relation (8.1) that could explain all of these empirical observations. One economically reasonable modification of the relation (8.1) which provides a systematic explanation for these events is the #expectations-augmented Phillips Curve#. The expectations-augmented Phillips curve was developed by Edmund Phelps and Milton Friedman in the late 1960s, in response to perceived theoretical deficiencies of (8.1); but the importance of their work was not accepted until the nineteen seventies, when the empirical deficiencies of (8.1) became obvious. HT postulate and use a simple form of the expectations-augmented Phillips curve, as follows: Y(T) - Y*(T) (8.4) INF(T,T+1) = INF^e(T,T+1) + f [----------------] Y*(T) where INF^e(T,T+1) = Expected inflation rate from T to T+1 as perceived by firms at the beginning of period T; f = positive exogenously given coefficient multiplying the GDP gap Important Note: For simplicity, HT assume throughout Chapter 8 that potential GDP Y*(T) takes on a #constant# value Y* over time, i.e., Y*(T) = Y* for all T; compare (8.4) with the HT text equation (8-1). This assumption requires consumer tastes to be constant over time (no shifts in the labor supply curve), and also technology and the capital stock K(T) to be constant over time (no shifts in the aggregate production function or in the labor demand curve). In particular, the assumption that K(T) does not change over time means that gross investment I(T) in each period T consists entirely of expenditures for the replacement of depreciated capital, so that net investment (gross investment less depreciation expenditures) is zero. This is clearly unrealistic, and is relaxed by HT after a more careful discussion in chapter 11 of the investment decision. For clarity, definitions and relations will be introduced and motivated in class lectures in the more general form (8.4) which does not presume constancy of potential GDP over time. Under relation (8.4), in contrast to (8.1), firms are assumed to have a more sophisticated understanding of inflation. If firms expect the inflation rate to be INF^e(T,T+1) from period T to period T+1, then firms will adjust their prices to keep them in line with the expected change in the general price level #even if the GDP gap is zero#. And a #positive# GDP gap will induce firms to increase their prices at a #faster# pace than the expected rate of inflation. Recall that internal balance requires the GDP gap to be #zero#. However, according to (8.4), having a zero GDP gap does #not# guarantee that the inflation rate is zero. Rather, a zero GDP gap is consistent with #any# inflation rate #as long as this inflation rate is fully anticipated in each period T#. More generally, as will be clarified in the next section and in later experiments with the complete HT model, (8.4) is consistent with the stagflation experience of the 1970s. That is, under (8.4), it is possible to have a situation in which the inflation rate is increasing at the same time that the GDP gap is becoming more negative---or in other words, a situation of stagflation in which inflation and unemployment are increasing together. F. DETERMINANTS OF EXPECTED INFLATION The simplest postulate concerning how firms form inflation expectations is that they expect the current inflation rate to be the same as it was in the previous period. More generally, they could form some kind of weighted average over the inflation rates they have observed over a number of previous periods. Expectations formed in this way---as weighted averages over past observations ---are said to be "adaptive." #Example 1: Adaptive Expectations for the Inflation rate# Firms determine their expected inflation rate INF^e(T,T+1) for period T to T+1 by taking a simple weighted average over past observed inflation rates: (8.5) INF^e(T,T+1) = a_1INF(T-1,T) + a_2INF(T-2,T-1) + ... #Example 2: Rational Expectations for the Inflation Rate# An alternative hypothesis concerning expectation formation which has become very fashionable in recent years is to assume that agents understand the actual mechanisms generating key economic variables, and they use this information to form "rational expectations." In particular, agents understand the structural relations which determine the inflation rate, and they use this understanding in formulating their inflation rate expectations. They don't simply extrapolate over past observations. Suppose, for example, that the #actual# inflation rate from T to T+1 is determined by the growth of the money supply from T to T+1; i.e., M^S(T+1) - M^S(T) (8.6) INF(T,T+1) = ------------------- M^S(T) = actual percentage change in the money supply M from T to T+1. Then agents' have #rational expectations# concerning the inflation rate from T to T+1 if these expectations are given by (8.7) INF^e(T,T+1) = the #expected# percentage change in M^S from T to T+1. Various factors might affect in some degree the way in which firms formulate an expected inflation rate: for example, past rates of inflation; monetary policy; and negotiated wage contracts, especially if these wage contracts include cost of living adjustments (COLAs). Economists making use of the expectations-augmented Phillips curve (8.4) generally assume that, regardless of how firms form their expectations, they tend to adjust their expectations to conform to their observations. In particular, it is assumed that firms continually adjust INF^e to conform more closely to observed values of INF. Given this assumption, relation (8.4) implies the following #accelerationist property#, sometimes also referred to as the #natural rate property#: NATURAL RATE PROPERTY: As long as actual GDP Y is maintained above (below) potential GDP Y*, the inflation rate INF will #perpetually increase (decrease)# as people keep attempting to adjust their inflation rate expectations to the actual inflation rate. Conversely, a #zero# GDP gap is consistent with any inflation rate INF #as long as this inflation rate is correctly anticipated#. G. SOME EMPIRICAL EVIDENCE Economists have estimated the relation (8.4) over various different time intervals, often relying on the following simple adaptive assumption for the expected inflation rate: namely, the expected inflation rate from T to T+1 is proportional to the actual inflation rate from T-1 to T. The following data is taken from S. Sheffrin, #The Making of Economic Policy#, Blackwell, 1991, p. 1989. The numbers in parentheses below the estimated coefficient values denote measured standard deviations. #Pre-WWII study:# 1873-1914: Y(T) - Y*(T) INF(T,T+1) = 0.22INF(T-1,T) + 0.34 [-------------] Y*(T) (0.14) (0.19) R^2 = 0.14 (goodness of fit measure, 1 = best possible) #Post-WWII study:# 1953-1982: Y(T) - Y*(T) INF(T,T+1) = 0.005 + 0.92INF(T-1,T) + 0.37 [------------] Y*(T) (0.07) (0.003) R^2 = 0.83 (goodness of fit measure, 1 = best possible) Comparing the two regressions, the coefficient f on output deviations is somewhat higher in the post-war era, indicating a somewhat higher price responsiveness to the GDP gap. The regression for the earlier period does not explain nearly as much variance in inflation as the postwar regression, however, as evidenced by the small goodness of fit measure. Inflation is much more persistent in the postwar error, in the sense that the coefficient on the lagged inflation term is much closer to 1.0 (implying that inflation in one period tends to spill over into the next period). In similar studies run for Italy, Sweden, and the U.K., all countries exhibited increased responsiveness of inflation to output movements in the post-war error (higher f estimates). Although not as clear-cut, evidence for Canada, Norway and Denmark shows that none of these countries exhibited any sharp decrease in responsiveness (decline in f) during the postwar era. On the other hand, for all these countries, the persistence of inflation (as measured by estimates of the coefficient on lagged inflation) was much higher in the post-war era. H. THE COMPLETE HT MODEL IN EQUATIONAL FORM Combining the labor market equations for the determination of potential GDP with the HT7 IS-LM model and the expectations-augmented Phillips Curve developed above, one obtains the complete HT model. This model will permit us to derive the movement of the economy from one short-run equilibrium to the next as the price level adjusts in response to either a nonzero GDP gap or a change in the expected inflation rate. #PERIOD T MODEL EQUATIONS FOR THE COMPLETE HT MODEL# #Product and Money Markets#: (1) [Adaptive Expectations] INF^e(T,T+1) = zINF(T-1,T) (2) [IS] R(T) = [a + e + G + g]/[d + n] - (1-b[1-t] + m)/[d + n])Y(T) (3) [LM] R(T) = - ( M/hP(T) + INF^e(T,T+1) ) + [k/h]Y(T) #Potential Values and Price Adjustment#: (4) [Potential Labor Supply] N*(T) = (1+u)^Th(w*(T)) NOTE: "u" denotes the population growth rate; and "w*(T)" denotes the period T benchmark #full employment# real wage, not necessarily the actual period T real wage (5) [Potential Labor Demand] w*(T) = AF_N(N*(T),K(T)) (6) [Potential Product Supply] Y*(T) = AF(N*(T),K(T)) (7) [Def of Inflation Rate] INF(T,T+1) = [P(T+1) - P(T)]/P(T) (8) [Phillips Curve] INF(T,T+1) = INF^e(T,T+1) + f[Y(T) - Y*(T)]/Y*(T) #Movement in Capital Stock over Time#: (9) [Gross Investment Function] I(T) = e - dR(T) (10) [Gross investment defined] I(T) = K(T+1) - K(T) + xK(T) Note: Here xK(T) denotes depreciated capital in period T. Gross investment is defined to be net investment, K(T+1)-K(T), plus depreciation expenditures, xK(T). #PERIOD T CLASSIFICATION OF VARIABLES# Ten Period T Endogenous Variables: R(T), Y(T), INF^e(T,T+1), INF(T,T+1), P(T+1), Y*(T), N*(T), w*(T), I(T), K(T+1) Period T Predetermined Variables: P(T), INF(T-1,T), K(T) Exogenous Variables: Positive Policy Variables G, M , t with 0 less than t less than 1 Positive Coefficients a, e, g, d, n, b, m, k, h, z, A, u, f, x #BOX DIAGRAM OF THE MOVEMENT OF THE ECONOMY OVER TIME#: ..................... . . . . . Period T Model . P(T),K(T),INF(T-1,T) --> . Equations (1)-(10).--> P(T+1),K(T+1),INF(T,T+1) . . State of the Economy . . State of the Economy at the Beginning of . . at the Beginning of Period T ..................... Period T+1 #SOLVING THE PERIOD T MODEL (1)-(10)#: By assumption, the period T predetermined variables P(T), K(T), and INF(T-1,T) are known at the beginning of period T, along with all exogenous variables. The ten period T endogenous variables can then be solved for as follows: (a) Given P(T) and INF(T-1,T), use (1), (2), and (3) to determine INF^e(T,T+1), Y(T), and R(T). (b) Given K(T), use (4) and (5) to determine N*(T) and w*(T) (c) Given K(T) and N*(T), use (6) to determine Y*(T) (d) Given P(T), INF^e(T,T+1), Y(T), and Y*(T), use the two equations (7) and (8) to determine the two unknowns P(T+1) and INF(T,T+1) (e) Given R(T), use (9) to determine I(T) (f) Given K(T) and I(T), use (10) to determine K(T+1) J. DYNAMIC RESPONSE TO CHANGES IN ECONOMIC CONDITIONS The dynamic model (1)-(10) permits the investigation of the dynamic response of the economy to #changes# in economic conditions. Here we give only a simple illustration, using various strong simplifying assumptions used also by HT in Chapter 8. In particular, following HT, suppose that the economy has a constant potential GDP level Y* over all time periods 0,1,2,... . In addition, suppose that money demand depends on the real rather than the nominal interest rate, so that INF^e(T,T+1) does #not# enter into the LM equation (3). Finally, suppose that the actual inflation rate INF(0,1) from period 0 to period 1 is zero. At the start of period 1, the economy is in internal balance with a target money supply M, a price level P(1), a real interest rate R*, a real GDP level equal to Y*, and an expected inflation rate INF^e(1,2) = 0. This position of internal balance is graphically depicted below: R . . . . E* R* . . . . . ...................................... Y 0 Y* P . . . . . A* P(1)................................................ . . . . . . . . . . . . ................................................ Y 0 Y* Price adjustment for the economy over periods T = 1, 2, ... takes place in accordance with the following expectations-augmented Phillips curve relation, which incorporates a simple adaptive expectation for the inflation rate: Y(T) - Y* (8.8) INF(T,T+1) = INF^e(T,T+1) + f [-------------] , Y* where P(T+1) - P(T) INF(T,T+1) = ---------------- ; P(T) INF^e(T,T+1) = zINF(T-1,T) = adaptive expectation for the inflation rate from T to T+1; f,z = positive exogenously given coefficients with z less than 1 Suppose the Fed unexpectedly #increases# the target money supply M at the beginning of period 1 to a #higher# level M'. QUESTION: How is internal balance reestablished in subsequent periods, if ever, assuming the Fed holds the money supply #constant# at the higher level M' in all future periods? First-Round Effects: A new short-run equilibrium is established in response to M --> M' at the initial price level P(1). The increase in the target money supply leads to a #downward# shift in the LM curve; the IS curve is not affected. Since initially the economy was in internal balance at E*, with M = M^D, and the new money supply M' is greater than M, there is now an excess supply of money. The interest rate will thus tend to fall, encouraging #more# money demand---i.e., the exchange of bonds (loan contracts) for money. The fall in the interest rate results in an increase in investment and net exports, and hence also to an increase in Y through multiplier effects. The drop in the interest rate and the increase in Y continue until a new IS-LM equilibrium is established at the higher money supply M' at E'(1) = (Y'(1), R'(1)), say. Thus, Y'(1) is greater than Y* , implying the existence of a positive GDP gap. Since the period 1 price level P(1) is unchanged, this implies an #outward# shift of the AD curve, say to the new curve AD'. R . . R* ..................... E* . . . . . . . . R'(1) ...................................... E'(1) . . . . . . . . . . . . ..............................................Y 0 Y* Y'(1) P . . . . . A* A'(1) P(1)............................................... . . . . . . ............................................... Y 0 Y* Y'(1) Second Round: The price level #increases# to P'(2) in response to the #positive# GDP gap. Since the #actual# inflation rate INF(0,1) from period 0 to 1 was zero, by assumption, the #expected# inflation rate INF^e'(1,2) = zINF(0,1) from period 1 to 2 is zero. However, after the increase in the money supply, the level of GDP Y'(1) for period 1 is higher than potential GDP Y*, i.e., there is a positive GDP gap (excess demand for goods). It follows from (8.8) that the initial price level P(1) will rise from period 1 to 2 to a new level P'(2) greater than P(1) as firms adjust their prices upward in the face of the positive real GDP gap: P'(2) - P(1) Y'(1) - Y* INF'(1,2) = --------------- = INF^e'(1,2) + f [----------] P(1) Y* (+) (0) (+) Third Round: A new short-run equilibrium is established at the higher price level P'(2). The increase in the price level from P(1) to P'(2) shifts the LM curve #up#; that is, in order to have money market clearing for the smaller real money supply implied by the higher price level P'(2), R must be higher for each GDP level Y to dampen money demand. Thus, at E'(1) with Y = Y'(1), the interest rate R'(1) tends to rise; and this leads to a #decrease# in Y'(1) through multiplier effects. Suppose the IS-LM equilibrium corresponding to the higher price level P'(2) is established at E'(2) = (Y'(2),R'(2)) with Y* less than Y'(2) and Y'(2) less than Y'(1). The GDP gap for period 2 is thus still positive, but smaller than it was in period 1. R . . R* . . E* . . R'(2) . E'(2) . R'(1) . . E'(1) . . . ....................................................Y 0 Y* Y'(2) Y'(1) P . . A'(N) P'(N) ................................................... . . . . . . . . A'(2) P'(2) ................................................... . . . . . . . . A* . A'(1) P'(1) ................................................... . . . . . . . . . . . . ................................................... Y 0 Y* Y'(2) Y'(1) Fourth Round: The price level increases to P'(3) in response to the positive GDP gap. Fifth Round: A new short-run equilibrium is established at the higher price level P'(3). and so forth...... The point is that the price level will keep on increasing as long as there is a positive GDP gap and the expected inflation rate is nonnegative. According to (8.8), the price level will cease changing from one period to the next---that is, the realized inflation rate will be zero---when two conditions are met simultaneously: (1) The GDP gap is zero [Y = Y*] (2) The expected inflation rate is zero The first of these conditions is met at (Y*,P'(N)), but the second need not be. If the price level P'(T) during some period T attains P(N) but agents still expect a positive inflation rate from T to T+1, then the price level in the next period, P'(T+1), will be greater than P'(T), and the economy will "overshoot" full employment real GDP Y* to some level Y(T+1) less than Y*. The GDP gap then becomes #negative#, leading subsequently to downward pressure on the price level through the Phillips Curve relation (8.8). Eventually this reverses the decline in real GDP, bringing it back toward Y*. Note from the IS-LM diagram above that the interest rate R must return to R* in order for internal balance to be reestablished at Y = Y*. Only the LM curve is shifting through-out these various round effects, hence a return to internal balance requires the LM curve to once again attain its original position in Y-R space. In particular, #real# money balances M/P must again equal M*/P(1). But since M* has increased to M', this requires the price level P(1) to increase to a new level, say P'(N), given by M' P'(N) = P(1) --- . M Note that P'(N) is greater than P(1) since M' is greater than M. Thus, in the internal balance position, both the nominal money supply M' and the price level P'(N) are higher than they originally were. However, notice also that internal balance could be re-established at Y=Y* with a #persistently# positive inflation rate if government were to continually #accommodate# the inflation rate by continually #increasing# the money supply, so that M/P maintains the value M/P(1) with a continually increasing M and P. This observation is a reflection of the position maintained by monetarists such as Milton Friedman that, in the long run, inflation is "everywhere and always a monetary phenomenon." The fact that real GDP Y and the real interest rate R eventually return to the initial internal balance point (Y*,R*) after the period 1 shock to the money supply is a key result of the natural rate macro theory espoused by many economists. According to this theory, a change in the money supply has no long-run impact on real variables such as Y and R. Rather, the only long-run impact of a change in the money supply is a change in the price level P. Notice, however, that a lengthy price adjustment process would realistically have significant affects on investment (capital) spending, and hence on full employment income; so that maintaining the constancy of Y* over time is not at all realistic. And if Y* is permanently affected by changes in monetary policy, then so is the ultimate internal balance position which emerges in response to a money supply shock. Consequently, many economists argue that money is not "neutral" in the sense of having no real affects unless the price level adjusts #instantaneously# to keep the GDP gap always at zero #and# expectations are always correct. FINAL REMARK: Suppose money demand depends on R^N = R + INF^e rather than just on R as HT assume. Does anything change? The answer is YES. As before, the price level will go up in response to the increase in M and consequent opening up of a GDP gap, which tends to shift the LM curve #up#. On the other hand, the sudden rise in price will lead to a revised higher expectation for the #inflation rate# INF, and this rise in INF^e causes a #downward# shift in the LM curve. If the latter effect dominates, the economy might move further and further away from the full employment level Y* in each successive period.