Question

How will an increase in the money supply affect aggregate demand?

Short answer

An increase in the money supply generally increases aggregate demand. It lowers interest rates, which decreases the cost of borrowing and encourages companies and households to spend and invest, resulting in an increase in aggregate demand.

Step-by-step solution

Understand the Concept of Money Supply

The money supply refers to the total stock of money in circulation among the public at a particular point in time in an economy. It includes cash, coins, and demand deposits. It's controlled by the central bank of a country, which can impact economic variables, like interest rates, by changing the money supply.

Understand the Concept of Aggregate Demand

Aggregate Demand (AD) is the total demand for all goods and services in a country at a specific time period, assuming all other factors remain constant. The components of AD are Consumption (C), Investment (I), Government Spending (G) and Net Exports (X-M). The aggregate demand curve is downward sloping, showing an inverse relationship between the price level and the quantity of output demanded.

Link Between Money Supply and Aggregate Demand

When money supply increases, it decreases the interest rate. As a result of this decrease, businesses and households have increased access to credit. There is an increase in investments as businesses can now borrow money at lesser interest rates. Households will also consume more due to lower interest rates and have a higher disposable income. The increase in consumption and investments leads to a rise in aggregate demand.