Question

Suppose the objective of the Fed is to increase Real GDP. To this end, it increases the money supply. Can anything offset the increase in the money supply so that Real GDP does not rise? Explain your answer.

Short answer

Yes, factors such as inflation, increased saving, global economic conditions, or a decrease in economic confidence can offset the increase in the money supply, preventing an increase in Real GDP.

Step-by-step solution

Understanding Monetary Policy

The Fed uses monetary policy to influence the economy. Increasing the money supply is one tool they use, which can stimulate economic growth and increase Real GDP. This is because with more money in the economy, people have more to spend, which can lead to increased demand for goods and services, leading to increased production (GDP).

Factors that Could Offset Increased Money Supply

However, there are factors that could offset the impact of an increased money supply. One such factor is inflation. When the supply of money increases rapidly, it can erode the value of money, leading to inflation. Inflation can counteract the intended effects of increasing the money supply by decreasing the purchasing power of consumers, thus possibly leading to reduced demand and lowered Real GDP. Other factors could include increased saving rather than spending by consumers, global economic conditions, or a decrease in confidence in the economy, leading to reduced investment.

Conclusion

So, while in theory increasing the money supply can lead to an increase in Real GDP, there are multiple factors that can offset this effect. Therefore, monetary policy alone cannot always guarantee an increase in Real GDP.