Question

Assume the central bank increases the quantity of money by 25%, even though the economy is initially in both short-run and long-run macroeconomic equilibrium. Describe the effects, in the short run and in the long run (giving numbers where possible), on the following: A. aggregate output B. the aggregate price level C. the real value of the money supply (its purchasing power for goods and services) D. the interest rate

Answer 1

Answer:

A. aggregate output - INCREASE

B. the aggregate price level - INCREASE

C. the real value of the money supply (its purchasing power for goods and services) - DECREASE

D. the interest rate - DECREASE

Explanation:

Generally speaking, by increasing the amount of money in the economy, the central bank encourages private consumption. Increasing the money supply also decreases the interest rate, which encourages lending and investment.

A. Aggregate Output: Increase in money supply triggers a growth in consumption and investment which leads to a higher aggregate demand. because the FED is basically giving more money to the household, which it will spend on consumption, by so doing triggering demand. It is also giving more money to business which they will spend on investment, which means they will increase the supply of goods and services.

B. the aggregate price level - In the short run, an increase in the supply of money does not affect price level but on the long run it causes price level to increase because inflation by definition is too much money in circulation.

C. the real value of the money supply (its purchasing power for goods and services) - As a follow on with the submission in 'B' above, on the long run, the purchasing power of money falls because of the increase in price-level and the existence of inflation.

D. the interest rate - Expansionary monetary policy which describes  an increase in the money supply,  will result in a fall in interest rates and businesses will be able to borrow more.