Question

Using the aggregate supply and demand model, assume the economy is in equilibrium on the intermediate portion of the aggregate supply curve. A decrease in the money supply will decrease the price level and a. lower both the interest rate and real GDP. b. raise both the interest rate and real GDP. c. lower the interest rate and raise real GDP. d. raise the interest rate and lower real GDP.

Short answer

A decrease in the money supply will lead to a decrease in consumption and investment, shifting the aggregate demand curve to the left and causing the equilibrium point to shift to a new position with a lower price level and a lower real GDP. Additionally, a decrease in the money supply usually leads to higher interest rates as there is less money circulating in the economy, making borrowing more expensive. Thus, the correct answer is option d: the decrease in the money supply will raise the interest rate and lower real GDP.

Step-by-step solution

Understanding the aggregate supply and demand model

The aggregate supply and demand model is a macroeconomic model that shows the relationship between the overall price level, real GDP, and the level of production within an economy. It consists of the aggregate demand (AD) curve, which represents the total demand for goods and services, and the aggregate supply (AS) curve, which represents the total supply of goods and services. The intersection between the AD and AS curves determines the equilibrium price level and real GDP in an economy.

Analyzing the effect of a decrease in the money supply

A decrease in the money supply will cause a decrease in the price level. This is because lower money supply reduces the amount of money available for spending, translating to lower aggregate demand. To understand how this affects the interest rate and real GDP, we need to analyze the AD curve. The AD curve can be expressed as AD = C + I + G + NX, where C is consumption, I is investment, G is government spending, and NX is net exports. A decrease in the money supply will affect consumption and investment, which will shift the AD curve.

Shift in the aggregate demand curve

The decrease in the money supply will lead to a decrease in consumption and investment, which will shift the AD curve to the left. This is due to the fact that people will have less money to spend and, to compensate for their lower purchasing power, they will cut back on consumption and investment. Consequently, this will cause the aggregate demand to decline.

Effects on real GDP and interest rate

Since the economy initially is in equilibrium on the intermediate portion of the AS curve, it is sensitive to changes in the price level. Therefore, as the price level decreases, the aggregate supply will increase due to the higher level of production at a lower price. With the decline in aggregate demand, the equilibrium point will shift to a new position with a lower price level and a lower real GDP. This means the answer is between option a and option d. Now let's analyze the effect on interest rates. A decrease in the money supply usually leads to higher interest rates since there is less money circulating in the economy, making borrowing more expensive. This further reduces investment and consumption. Therefore, the correct answer is option d: the decrease in the money supply will raise the interest rate and lower real GDP.

Key concepts

Equilibrium in Macroeconomics

In macroeconomics, equilibrium refers to a state where Aggregate Supply (AS) and Aggregate Demand (AD) are balanced. This occurs at the intersection of the AS and AD curves within the aggregate supply and demand model. At this point, the economy operates at a specific price level and real GDP. It's essential to recognize that equilibrium isn't static; it's dynamic and can shift in response to various economic factors like changes in fiscal policies, consumer confidence, or global events.
An economy in equilibrium is operating efficiently. Resources are effectively allocated without excess supply or demand. If left undisturbed, this state could theoretically persist indefinitely. Understanding equilibrium helps us predict how an economy reacts to changes, guiding policymakers in maintaining stability and growth.

Aggregate Demand Curve

The Aggregate Demand (AD) curve represents the total demand for goods and services within the economy at varied price levels. It's inclined downward, indicating that as the price level drops, the quantity of goods demanded tends to rise and vice versa. The components of the AD curve include

• Consumption (C)
• Investment (I)
• Government Spending (G)
• Net Exports (NX)

These elements together show how different sectors of the economy contribute to total demand.
Let's illustrate what causes the curve to shift. Factors like consumer income, interest rates, and government policies can shift the AD curve right (increase) or left (decrease). For instance, a decrease in the money supply, as outlined in the exercise, causes the AD curve to shift leftward. This shift indicates a fall in overall demand due to reduced consumption and investment. Understanding the aggregate demand curve is crucial because it helps explain how changes in economic conditions can impact demand and overall economic performance.

Money Supply Effects

The money supply in an economy is crucial for determining interest rates and economic performance. It's often controlled by the central bank through monetary policy. When the money supply decreases, as in the given exercise, several effects can occur on the economy:

• Interest Rates: A decrease in money supply generally raises interest rates, as money becomes more scarce, increasing the cost of borrowing. Elevated interest rates can lead to reduced investment and spending.
• Price Levels: With less money in circulation, the price level tends to fall, which can reduce inflationary pressures. However, this also means reduced aggregate demand.
• Real GDP: As outlined earlier, a decrease in the money supply may lead to a decrease in real GDP, due to reduced consumption and investment. Companies produce less, impacting employment and overall economic growth.

Understanding the effects of changes in money supply is essential for both policymakers and business leaders. It helps them make informed decisions to foster economic stability and growth.