Macroeconomics For Dummies®, uk edition Published by: John Wiley & Sons, Ltd

Understanding that money is neutral in the long run

Throughout this chapter and indeed this book you may notice that monetary policy has little effect on the economy in the long run. It has no effect on output (Y) or the real interest rate (r) or the level of unemployment. Neither does it have any effect on consumption (C), investment (I), the real wage or the real exchange rate.

This is no accident! In fact, it’s a reflection of a very important result in macroeconomics: the classical dichotomy, which says that in the long run, money has no effect on real variables, like output, unemployment or the real interest rate – it only affects nominal variables.

Monetary policy can, however, affect real variables in the short run. To convince yourself, consider an increase in aggregate demand caused by expansionary monetary policy. This typically increases output, reduces unemployment and reduces the real interest rate in the short run.

Monetary policy does influence nominal variables, such as the price level, nominal interest rate, inflation rate and nominal exchange rate in the long run. To see why, consider what would happen in the long run if the quantity of

money in an economy doubled: all prices including nominal wages would double too. But no one would be any richer, because everything you could buy before, you could still buy now. Furthermore, the relative prices between different goods (for example, two bananas cost the same as one pear) would remain unchanged.
Chapter 11


Fiscal Policy: Balancing the Books – Perhaps


In This Chapter


Understanding fiscal policy


Discovering two competing views
Fiscal policy refers to policy makers’ policy (that’s a lot of ‘policy’!) as it relates to government expenditure and taxation: it impacts your own and everyone’s lives in profound ways:


When you receive your monthly pay (and sigh heavily because it’s always less than you want), the amount of your salary that you get to keep after taxes depends on fiscal policy.


When you spend your salary, fiscal policy impacts the price you pay for goods and services, whether you’re renting the latest Hollywood blockbuster on DVD or buying tickets for the opera. For example in the UK, value added tax (VAT) adds 20 per cent to the price of most goods and services (including that Channing Tatum action flick, but not fruit and veg).


When you get sick and visit your doctor (and you’re lucky enough to live in a country where the government provides health services), the quality of the treatment you receive depends on fiscal policy.


When you send your children to a state school, you’re receiving a transfer that pays for their education due to fiscal policy.

Very few areas of economic life aren’t impacted by fiscal policy, so changes in it have the potential to create large impacts on individuals and the economy. To see how fiscal policy affects aggregate demand and supply, check out Chapter 9. Here you discover how fiscal policy affects the economy and the constraints that policy makers face when undertaking it.