The Fed expands the money supply by 5 percent. a. Use the...

The Fed expands the money supply by 5 percent. a. Use the theory of liquidity preference to illustrate in a graph the impact of this policy on the interest rate. b. Use the model of aggregate demand and aggregate supply to illustrate the impact of this change in the interest rate on output and the price level in the short run. c. When the economy makes the transition from its short-run equilibrium to its new long-run equilibrium, what happens to the price level? d. How does this change in the price level affect the demand for money and the equilibrium interest rate? e. Is this analysis consistent with the proposition that money has real effects in the short run but is neutral in the long run?

The Fed expands the money supply by 5 percent.
a. Use the theory of liquidity preference to illustrate in a graph the impact of this policy on the interest rate.
b. Use the model of aggregate demand and aggregate supply to illustrate the impact of this change in the interest rate on output and the price level in the short run.
c. When the economy makes the transition from its short-run equilibrium to its new long-run equilibrium, what happens to the price level?
d. How does this change in the price level affect the demand for money and the equilibrium interest rate?
e. Is this analysis consistent with the proposition that money has real effects in the short run but is neutral in the long run?

Key Concepts

Monetary Policy Expansion

This concept refers to the use of tools by a central bank, such as increasing the money supply, in order to influence economic variables. When the central bank expands the money supply, it typically lowers the cost of borrowing, influences liquidity in the financial system, and can affect overall economic activity by shifting various curves in macroeconomic models.

Liquidity Preference Theory

Liquidity Preference Theory explains how individuals choose between holding their wealth in liquid form or as interest-bearing assets. It posits that the demand for money depends on the interest rate, with higher rates leading to lower demand for liquidity. This theory helps illustrate how changes in the money supply, through its impact on liquidity, can lead to changes in the equilibrium interest rate.

Aggregate Demand and Aggregate Supply Model

The AD-AS model is used to analyze the relationship between total spending (aggregate demand) and total production (aggregate supply) in an economy. Changes in monetary policy, such as an increase in the money supply, can influence aggregate demand, thereby affecting output and price levels in the short run. This model provides a framework for understanding how shifts in demand or supply curves lead to new short-run equilibriums.

Short-run vs Long-run Economic Effects

This concept distinguishes the immediate, temporary impacts of economic policies from their eventual outcomes once all adjustments have taken place. In the short run, monetary policy can have real effects—such as changes in output or employment—often due to sticky prices or wages. However, over the long run, the economy may adjust through changes in the price level and expectations, often leading to the neutrality of money, whereby real variables return to their natural levels.

Money Neutrality

Money Neutrality is the proposition that changes in the money supply only affect nominal variables, such as the price level, and have no lasting impact on real economic variables like output or employment in the long run. This concept clarifies that while monetary expansion might stimulate the economy temporarily, its influence dissipates in the long term as prices adjust, thus neutralizing the real effects of the policy.

Transcript

00:01 Moving on to question two, we're being given that the federal reserve expands the money supply by 5%.

00:07 In part a, we need to use the theory of liquidity preference to illustrate in a graph the impact of this policy on the interest rate.

00:16 Well, following from question one, we know that the theory of liquidity preference can be illustrated very vividly using the supply and demand graph in the money market.

00:29 On the x -axis, we'll have the quantity of money m.

00:32 On the y -axis, we have the interest rate r.

00:34 The money demand curve will be downward sloping, and as always, the money supply curve will be vertical because it's fixed by the central bank.

00:43 Here, since the fed expands the money supply by 5%, this means that we have a rightward shift, the money supply curve from ms1, ms2.

00:53 And as a result, the initial interest rate r1 will decline, and reach r2 right here.

01:03 All right.

01:04 In part b, we need to use the model of aggregate demand and aggregate supply to illustrate the impact of this change in the interest rate, impact of the change in the interest rate on output and the price level in the short run.

01:17 All right.

01:18 Well, we know how to do that.

01:21 We'll use the standard aggregate supply, angry demand graph.

01:24 On the xx, we have the quantity of output, but y on the y -axis, we have the price level p.

01:31 As always, the long -grand aggregate supply curve will be vertical and intersect the x -axis at the natural level of output y -1.

01:40 And the economy now is initially operates at the aggregate demand curve ad1 and the aggregate supply curve as1.

01:50 So the economy is initially at point a.

01:53 Now, since the fed expounds the money supply, and the equilibrium interest rate will decline.

02:01 And as a result, households will increase their spending and invest more in new consumption goods, maybe invest in durable goods, or maybe even new housing...

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