Practice a College Board-style free response question on Long-Run Consequences of Stabilization Policies. Write your response, then reveal the model answer to see exactly what earns each point.
The country of Veranda has been running persistent government budget deficits for the past decade, financed in part by money supply growth that has consistently outpaced real GDP growth. The central bank has also periodically tried to lower unemployment below the natural rate using unexpected increases in the money supply.
According to the quantity theory of money (M × V = P × Y), with velocity (V) relatively stable, the growth rate of the money supply (M) must show up as growth in either the price level (P) or real output (Y). Since real output in the long run is determined by an economy's resources and technology — not by the quantity of money — any money supply growth beyond what real GDP growth requires shows up almost entirely as inflation rather than additional real output.
In the short run, unexpected money growth can temporarily lower unemployment below the natural rate by moving the economy along the short-run Phillips curve — workers and firms are initially surprised by the resulting inflation. However, once workers and firms adjust their inflation expectations to match the actual, higher inflation rate, the short-run Phillips curve shifts up, and unemployment returns to the natural rate. The long-run Phillips curve is vertical at the natural rate of unemployment, meaning there is no permanent trade-off — Veranda's central bank will end up with the same unemployment rate it started with, but a permanently higher rate of inflation.
Persistent budget deficits require the government to borrow continuously, which increases the demand for loanable funds in the loanable funds market. This shifts the demand curve right, raising the real interest rate. The higher real interest rate makes borrowing more expensive for private firms, crowding out private investment in physical capital. Because investment in capital is a key driver of long-run economic growth, this sustained crowding out can slow Veranda's long-run growth rate by reducing the rate at which its capital stock — and therefore its productive capacity — expands over time.