Impacts

Increase in Money supply

There is no Central Bank on our island. The only way for more money to show up is the unlikely arrival of another few boxes of golf balls. Let's assume that this happens (a ship carrying the balls to the US Open was lost at sea) Let's assume further that the inhabitants of the island decide to share the balls equally. What happens? The supply of Money increases, but demand for money doesn't.

Initially, this may look like a temporary wealth effect - but it is not, since everyone has same impact and it does not change real products or production, only money (golf balls). Imagine the market for fish the day after these US Open golf balls wash up on shore. Consumers are smiling, having more golf balls than ever before. When two consumers approach the fish seller, prices may start where they were yesterday, but the fish buyers soon will find they are willing to pay more because they have more golf balls. These same buyers may also be sellers of thatch for housing, and they find that they get more for thatch in the same way.

So all prices will rise so as to increase the need for golf balls, and thus equate supply and demand for money. So a change in the monetary base of an economy, under our assumptions, will increase the prices, but not affect any quantities (goods, hours, etc.). This is, once again, the neutrality of money in action.

Labor market

After a while, people have decided to specialize a lot in their production. And some have good ideas for making more complex goods. Instead of working individually, they find they can create more value by working together - one cutting and another assembling and yet another selling, for example. Owners start these organizations and pay an hourly wage to the workers. This is also great for some people who did not like how their income fluctuated before, when they were selling each day. We assume that the wages are very flexible, and that an hour worked is worth the same for everyone, so there is only one wage level in the economy. The wage will act as a market clearing device: if there is too much labor supplied, compared to the demand, wages will go down, making some people opt for more leisure, and vice versa. It is very important to realize that what matters is the real wage (wage divided by general price level). What the workers look at is how many goods they can buy if they work one more hour, not how many golf balls they get. Hence, the neutrality of money will hold on the labor market as well as on the commodity market: only changes on the money market (money demand and money supply) will change the general level of prices. Furthermore, given that there are no changes in labor supplied or labor demanded, nominal wages will change in proportion to the change in the level in prices. Changes in labor supplied or labor demanded will have an effect on the real wage, since the change on the labor market will not affect the price level but will affect the wage level.

What would happen if there were a temporary increase in productivity? For example, four people used to fish, clean, and sell fish, averaging 100 fish a day. Then they join forces, with two fishing exclusively, one cleaning, and one selling, and they find they can average 150 fish a day.

With the wealth effect, consumption demand increases and labor hours (supply) decreases (can work less and still have more consumption). This remains exactly the same here. The change is the substitution part. Workers only respond to changes in wealth (including changes in real wages), but an increase in productivity makes it more attractive for the entrepreneurs to hire laborers, increasing labor demand. The overall effect is that the real wage increases, but once more the total effect on hours worked on the island is unclear. When the shock is temporary, we can safely assume that the demand effect will be stronger, thus increasing total hours worked in the economy. In the case of a permanent shift, it is less clear.