Chapter 13: Problem 13

If the Fed increases the money supply, what will happen to each of the following (other things being equal)? a. Interest rates b. Money demand c. Investment spending d. Aggregate demand c. The cquilibrium level of national income

Short Answer

Expert verified

Answer: An increase in the money supply by the Federal Reserve typically leads to lower interest rates, increased money demand, higher investment spending, increased aggregate demand, and an increase in the equilibrium level of national income.

Step by step solution

a. Interest Rates

When the Fed increases the money supply, it generally leads to lower interest rates. This is because an increase in the money supply means there is more money available to be lent to borrowers. When the supply of loanable funds increases, lenders lower the interest rates to attract more borrowers. Therefore, an increase in the money supply typically causes a decrease in interest rates.

b. Money Demand

An increase in the money supply doesn't necessarily change the money demand directly, as money demand is primarily affected by economic agents' need for liquidity. However, as a result of the decrease in interest rates that we discussed in part (a), people may choose to hold onto more cash rather than investing or saving it, since the returns on those investments or savings are now lower. This, in turn, can lead to an increase in the overall demand for money.

c. Investment Spending

When interest rates decrease, as we saw in part (a), the cost of borrowing decreases, and firms are more likely to take advantage of these lower rates to invest in new projects. As a result, investment spending should increase when the Fed increases the money supply.

d. Aggregate Demand

Higher investment spending, as we saw in part (c), is likely to result in an increase in aggregate demand. Additionally, lower interest rates also mean lower borrowing costs for consumers, which can lead to increased consumer spending. This increase in investment and consumer spending should cause aggregate demand to increase.

e. The Equilibrium Level of National Income

As aggregate demand increases, there is a corresponding increase in production and economic activity to meet this higher demand. This increase in economic activity leads to an increase in national income. Moreover, as firms hire more workers to produce these additional goods and services, the overall level of employment should rise, further increasing national income. Thus, an increase in the money supply will likely lead to an increase in the equilibrium level of national income.