Chapter 30: Problem 2

Contrast the short-run effects of an increase in the money supply on the interest rate to the long-run effects of an increase in the money supply on the interest rate. Which market determines the interest rate in the short run? Which market does so in the long run? What are the implications of your answers for the effectiveness of monetary policy in influencing real GDP in the short run and the long run?

Short Answer

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In summary, increasing the money supply has short-run and long-run effects on the interest rate. In the short run, it leads to a decrease in interest rates, stimulating investment and consumer spending, which increases real GDP. In the long run, however, nominal interest rates increase due to higher expected inflation, and real interest rates remain constant, leaving real GDP unaffected. The short-run interest rate is determined by the money market, while the long-run interest rate is determined by the loanable funds market. This suggests that while monetary policy can boost economic activity in the short run, factors such as productivity, technological progress, and the labor force determine long-term growth.

Step by step solution

Explaining the short-run effects of an increase in the money supply on the interest rate

An increase in the money supply leads to a surplus of money in the market, meaning there is more liquidity available for borrowing. As a result, the demand for money (loans) increases, while the supply of money also increases. The equilibrium interest rate decreases, as there is an increased availability of money, and lenders are more willing to provide loans at lower rates.

Explaining the long-run effects of an increase in the money supply on the interest rate

In the long run, the increase in the money supply leads to inflation, as there is more money chasing the same amount of goods and services. As the general price level rises, people start to expect higher inflation in the future. To compensate for this expected inflation, nominal interest rates will increase. An increase in nominal interest rates means that the real interest rate (nominal interest rate - expected inflation) remains constant in the long run.

Identifying the markets determining the interest rate in the short run and the long run

In the short run, the money market, which consists of the supply and demand for money, determines the interest rate. In the long run, the loanable funds market, which consists of the supply and demand for loanable funds, determines the interest rate. The loanable funds market takes into account the expected inflation rate, savings, investment, and government budget.

Discussing the implications of our analysis for the effectiveness of monetary policy in influencing real GDP in the short run and the long run

In the short run, expansionary monetary policy (increasing the money supply) can lower the interest rate, which stimulates investment and consumer spending, leading to an increase in real GDP. However, in the long run, the increase in the money supply leads to higher inflation expectations and, consequently, higher nominal interest rates. Real interest rates remain constant, and there is no effect on the level of real GDP in the long run. This indicates that monetary policy can be effective in stimulating economic activity in the short run, but it cannot create sustained, long-term growth. In the long run, other factors such as productivity, technological progress, and the labor force determine real GDP growth.

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