Question

Assume the central bank increases the quantity of money by 25%, even though the economy is initially in both short-run and long-run macroeconomic equilibrium. Describe the effects, in the short run and in the long run (giving numbers where possible), on the following.

a. Aggregate output

b. Aggregate price level

c. Interest rate

Short answer

a. The aggregate output will rise in the short run but will remain the same in the long run.

b. The price will increase in both short as well as long run.

c. The interest rates will fall in the short run and will remain the same in the long run.

Step-by-step solution

Explanation for part (a)

When the money supply increases, the interest rates fall, and the demand in the economy increases. This increased demand results in an increased output level in the economy, which is more than the initial equilibrium level of output. However, this phenomenon is only relevant in the short run.

In the long run, as the money supply increases and interest rates fall, the demand increases rapidly; thus, self-adjusting market forces work, and the interest rates increase, which again reduces the demand. Therefore, the aggregate output stays at the equilibrium level.

Explanation for part (b)

The price level is proportionally and directly related to the money supply; therefore, if there is an increase in the money supply by 25%, this will increase the economy's price levels by 25%.

This holds for the short as well as for the long run. In fact, in the long run, with increased money supply, no real variables changes, but the only price is changed. Thus, money is said to be neutral in the long run.

Explanation for part (c)

In the short run, when the money supply increases, the interest rates will go down since the supply of money increases and the demand is constant.

But during the long run, the increased money supply causing the interest rates to go down will increase the demand for money so much that there will be a shortage of money supply. Thus, the market forces will work, and the interest rates will be pushed back to equilibrium.