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Chapter 13: Problem 4

When the money supply increases, output rises before prices. Why?

Short Answer

Expert verified
An increase in the money supply initially leads to lower interest rates, which stimulates spending and investment. This increases demand for goods and services, leading to an increase in output as firms respond. Over time, persistent excess demand leads firms to raise prices, but output changes quicker than prices, hence output rises before prices.

Step by step solution

01

The Impact of Increased Money Supply

Initially, when the money supply increases, there is more money available in the economy. This leads to decrease in the interest rate. Lower interest rates make borrowing cheaper and encourage consumers to spend and firms to invest which stimulates economic activity.
02

The Effect on Output

As a result of the increased spending and investment, demand for goods and services increases which leads firms to increase their output to meet the higher demand. This rise in output occurs before prices increase because firms first respond to the higher demand by increasing production.
03

The Delayed Effect on Prices

Over time, as demand continues to outpace supply, firms start to raise prices in response to the persistent excess demand. However, this process takes time as firms often adjust their output levels more quickly than their prices. This explains why output rises before prices when the money supply increases.

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Most popular questions from this chapter

Even though changes in government spending principally affect the demand side of the economy, a change in taxes can affect both the demand side and the supply side of the economy. Do you agree or disagree? Explain your answer

Because firms adjust output before prices, what information do they lack?

Define: a. stagflation b. stop-and-go, on-andoff monetary policy

In the past how did economists view the relationship between unemployment and inflation? When did economic events begin to change this view?

Explain in detail how some economists believe the Fed causes stagflation. What is an alternative view of what causes stagflation?
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