Question

Suppose the money supply rises on Tuesday and by Thursday the interest rate has risen also. Is the rise in the interest rate more likely the result of the income effect or of the expectations effect? Explain your answer.

Short answer

The rise in the interest rate is most likely the result of the expectations effect. This is because the increase in money supply may lead to an expectation of future inflation, making lenders raise interest rates to compensate for anticipated decrease in the value of money. The income effect is not as immediate or relevant in this context.

Step-by-step solution

Understanding the Concepts

Firstly, it's important to understand the terms. The 'income effect' refers to the change in the demand for a good or service caused by a change in a consumer's purchasing power due to a change in real income. On the other hand, the 'expectations effect' refers to the impact on economic behavior due to what people anticipate will happen in the future. With respect to monetary policy, if people expect inflation, they may demand higher interest rates for loans to compensate for the loss in purchasing power over time.

Analyze the Situation

Given that the money supply rises on Tuesday, this means that there is more money circulating in the economy. As a short-term effect, this would generally lead to lower interest rates, as there is more money available to lend. But by Thursday, if the interest rates have risen, it indicates that bankers and lenders predict inflation due to the increase in money supply.

Concluding the Result

Based on this, it could be inferred that the rise in the interest rate is more a result of the expectations effect rather than the income effect. The lenders might have increased the rate because they expect inflation in the future, which is characteristic of the expectations effect. The income effect is not as relevant in this scenario, because it is typically associated with consumer behavior, and it would take more time to translate into a change in interest rates.