CHAPTER 23 GLOBAL Monetary and Fiscal Policy in the ISLM Model 613 International Evidence on Long-Run Monetary Neutrality Over the years, the long-run neutrality proposition has been investigated in a large number of studies, often with conflicting results Apostolos Serletis and Zisimos Koustas argue that meaningful long-run monetary neutrality tests depend on the time series properties of the variables, and they test the long-run neutrality of money proposition using recent advances in the field of applied econometrics.* In doing so, they use the Backus and Kehoe data set, consisting of over one hundred years of annual observations on real output and money for ten countries: Australia, Canada, Denmark, Germany, Italy, Japan, Norway, Sweden, the United Kingdom, and the United States The results show that the data are supportive of the proposition that money is neutral in the long run The same authors find support for the long-run neutrality of money using weighted monetary aggregates for the U.S economy.** As already noted in Chapter 3, weighted monetary aggregates represent a significant advance over simple sum measures of money However, international evidence on another important long-run neutrality proposition, the Fisher effect, seems to provide little support to the hypothesis that fully anticipated inflation has a unit effect on nominal interest rates.*** The preponderance of the evidence suggests that anticipated inflation has less than a unit effect on nominal interest rates, and thus reduces real interest rates even in the longest of runs The apparent contradiction of the two types of long-run neutrality results represents a puzzle that needs to be addressed by future theoretical and empirical research * See Apostolos Serletis and Zisimos Koustas, International Evidence on the Neutrality of Money, Journal of Money, Credit and Banking 30 (1998): pp 25 For details regarding the Backus and Kehoe data set, see David K Backus and Patrick J Kehoe, International Evidence on the Historical Properties of Business Cycles, American Economic Review 82 (1992): pp 864 888 ** See Apostolos Serletis and Zisimos Koustas, Monetary Aggregation and the Neutrality of Money, Economic Inquiry 39 (2001): pp 124 138 *** See Zisimos Koustas and Apostolos Serletis, On the Fisher Effect, Journal of Monetary Economics 44 (1999): pp 105 130 ISL M MO DE L AN D T HE AG G RE GAT E DE MA ND C URV E We now examine further what happens in the ISLM model when the price level changes When we conduct the ISLM analysis with a changing price level, we find that as the price level falls, the level of aggregate output rises Thus we obtain a relationship between the price level and quantity of aggregate output for which the goods market and the market for money are in equilibrium, called the aggregate demand curve This aggregate demand curve is a central element in the aggregate supply and demand analysis of Chapter 24, which allows us to explain changes not only in aggregate output but also in the price level Deriving the Aggregate Demand Curve Now that you understand how a change in the price level affects the IS and LM curves, we can analyze what happens in the ISLM diagram when the price level changes This exercise is carried out in Figure 23-11 Panel (a) contains an ISLM diagram for a given value of the nominal money supply Let us first consider a price level of P1 The LM curve at this price level is LM (P1), and its intersection with the