Suppose that prices are completely rigid, so that the nominal and the real inter

Question

Suppose that prices are completely rigid, so that the nominal and the real interest rate are

a. Suppose that government purchases increase, and that the central bank adjusts the money supply to keep the interest rate unchanged.

i. Does the money supply rise or fall?

ii. What happens to consumption and investment?

b. Suppose that government purchases increase, and that the central bank adjusts the money supply to keep output unchanged.

i. Does the money supply rise or fall?

ii. What happens to consumption and investment?

c. Suppose that government purchases increase, and that the central bank keeps the money supply unchanged.

i. Does the interest rate rise or fall?

ii. What happens to consumption and investment?

Explanation / Answer

(a) (i) As government is increasing its purchases, its demand for money will also increase.

if money supply remains same then this increase in demand for money will result in rise in interest rate.

However, if central bank wants to keep the interest rate unchanged then it have to bring an increase in money supply as well. Moreover, this increase in money supply should be equal to the increase in money demand as then only will interest rate remain unchaged.

So, money supply will rise.

(ii) Even though money supply is rising but interest rate is remaining unchanged. So, real cost of borrowing for households and firms will remain same and thus no change in consumption and investment will happen.

(b) If government is increasing its purchases, then aggregate demand will increase. In such case, equilibrium output will increase. If central bank wants to keep the equilibirum output unchaged then in that case it have to bring decrease in any other component of aggregate demand.

This will negate the impact of increase in government purchases on aggregate demand and will keep it at same level and with that output will also remain unchaged.

The central bank can does this by reducing money supply. This will raise the interest rate and thus reduce the investment spending and consumption spending backed by credit. Fall in these two heads will bring a fall in aggregate demand and negate any increase in aggregate demand associated with increase in government spending thereby keeping output unchanged.

(i) Thus, money supply will fall.

(ii) Consumption and investment will decrease.

(c) As government is increasing its purchases, its demand for money will also increase.

if money supply remains same then this increase in demand for money will result in rise in interest rate.

Rise in interest rate will increase the real cost of borrowing for the households and businesses and thus consumpiton and investment backed by credit will decline.

Thus,

(i) Interest rate will rise.

(ii) Consumption and investment will decrease.

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