Question

Suppose the Federal Reserve decided to increase money supply in the U.S. market. Would it affect the interest rate? Also, what can you say about its short-run and long-run effect on the overall price (P) and output (Y)? You must provide graphical analysis (Use AD, SRAS, and LRAS curves) and your discussions should be at least 500 words.

Answer 1

Any change in the money supply by Fed has a direct impact on the level of interest rate in the economy. If Fed decides to increase the money supply in the U.S. market, then it will either reduce reserve requirements or purchase government securities in the open market. These changes will increase the level of money supply in the economy. In the IS - LM framework it can be depicted by the rightwards shift of the LM curve of the economy. This increase in the money supply will reduce the level of interest rate in the economy.

Since rate of interest represents the cost of investment, reduction in the level of interest rate will increase the investment expenditure in the economy because of negative relationship between rate of interest and investment level in the economy. Since aggregate demand = consumption expenditure + investment expenditure + Government expenditure + Net Exports, an increase in investment expenditure will increase aggregate demand and thus shift the aggregate demand curve of the economy rightwards in the short run. Thus, in the short run both the price level and output will increase in the economy and exceed the potential level of output in the economy.

In the long run, increase in output will increase the demand for labor and thus unemployment will fall. This will increase bargaining power of workers vis-a-vis employers and thus real wage rate in the economy will rise. This will increase cost of production and thus shift the SRAS curve leftwards because supply declines with increase in cost of production. Thus, in the long run economy will return to its potential level of output and price level in the economy will rise.

The impact can be depicted graphically as follows: