a) How does the increase in money supply affect output and interest rate in coun
ID: 1104116 • Letter: A
Question
a) How does the increase in money supply affect output and interest rate in country X, if we assume that price level and expected price level are constant? Explain your answer.
b) Suppose you believe that investment is very elastic to interest rate , how will you modify your answer for a)? Explain your answer.
c) Suppose your friend is also interested in how output and interest rate are affected in the further future when price level can adjust but expected price level is still constant. How will you modify your answer for a)? Explain your answer.
d) Suppose your friend is also interested in how output and interest rate are affected in the even further future, when both price level and expected price level can adjust. How will you modify your answer for a)? Explain your answer carefully.
Your friend then asks you how private investment is affected by the change in . Please answer your friend under different assumptions: i) price level and expected price level are constant, ii) price level can adjust but expected price level is constant and iii) both price level and expected price level are flexible. Explain your answer. (No graph is needed)
Explanation / Answer
In country X if we increase the money supply by keeping the price level same, the Interest rate will fall & demand for commodities will go up. Consumers holding the excess money will demand more Interest baring Financial assets. The demand for alternate goods will also go up as consumers will spend more. The output will also go up as producers will produce more goods to meet the demand.
The relationship between the money supply & interest rate can be explained with below equation.
Aggregate Money demand at given price level is the function of Real National income & interest rate.
Md/p= L(Y*I) : Y= National Income , I = Interest Rate
L(Y*I)= Aggregate Money supply.
b.
With the lower interest rate the investment will go up. The business will borrow more money at lower interest rate.
The cost of borrowing will go down & that will have positive impact on business spending.
c. When Price level can be adjusted but expected price level will remain same you need higher liquidity to buy same level of goods. At higher Price level the demand for money will be higher & Interest rate will also remain high, to bring it to equilibrium we need to increase the money supply. The higher Price level the demand for money will be high.
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