Now that we have determined the cffccrs of monetary policy changes (changes in the money supply) on nominal interest rates, we turn our attention to the effect on the overall economy. In the short run, the effects of money supply changes on nominal interest rates will be the same for real interest rates. Let's first consider the effects of an increase in the money supply that leads to decreases in nominal and real interest rates.
Lower real rates will cause businesses to invest more and households to increase purchases of durable goods, automobiles, and other items that are tvpicallv financed at short-term rates. Thus, the business investment (I) and consumer spending (C) components of aggregate demand both increase.
Lower real interest rates will make investment less attractive to foreigners, who will tend to move money out of the country, selling the domestic currency and decreasing domestic currency/foreign currency exchange rates. This will make exports less expensive to foreign buyers and exports will increase. At the same time, imports will decrease as the domestic currency price of foreign goods increases. Thus, the net exports (X) component of aggregate demand increases.
The effect of the interest rate decrease in the short run will be even stronger because there is a multiplier effect. The increase in aggregate demand and expenditures will cause incomes to go up, which further increases consumption and investment. This spending on investment and consumption, in turn, also increases (someone's) income. This process is repeated and, even though not all of each consumer's increase in income is used to increase consumption, the eventual effect on consumption and aggregate demand will be much greater than the initial increase in consumption and aggregate demand.
This increase in aggregate demand will increase real GDP and the price level, as we saw in our analysis of the aggregate supply-aggregate demand model. Action by the central bank to decrease the money supply and increase rates will have the opposite effect. Rising rates will reduce household purchases, business investment, net exports, and aggregate demand, resulting in a decrease in real GDP and the price level.
If the economv is operating at the full-emplovment level (long-run aggregate supplv 1 when the central bank increases the monev supplv, the increase in real GDP must be lemporan. Recall that when an increase in aggregate demand increases real GDP ahow full-emplovment GDP, monev wages and the cost of other productive resources will rise, causing a shift to a new short-run aggregate supplv curve. Thus, the long-run effect of an increase in the monev supplv will simplv be an increase in the price level (rate of inflation) as the economv returns to full-emplovment GDP on the long-run aggregate supply curve. This is illustrated in Figure 4. 1 he right-hand side oi the figure is the same initial and long-run response to an increase in aggregate demand (from AD() to ADj) that we saw in the review of aggregate supply and aggregate demand. Initially, the price level rises to Pj, and the resulting increase in inflation decreases the real wage so that SAS shifts from SAS() to SAS,. The new long-run equilibrium real GDP is back to potential real GDP (along LAS) and the price level has increased to Pr Note that when the price level has increased to the increase in the price level has just offset the increase in the nominal money supply, so the real money supply returns to MS(). This long-run adjustment is illustrated in Figure 4(a). As a result of this decrease in the real money supply, the equilibrium interest rate returns to its original equilibrium level of 5% in Figure 4.
Figure 4: An Increase in the Money Supply at Full-Employment GDP
(a) Increase in the Money Supplv
(b) Resulting increase in Aggregate L )emand
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