1Problem Set 5
Complete all questions listed below. Clearly label your answers.
What impact will an unanticipated increase in the money supply have on the real interest rate, real output, and employment in the short run? How will expansionary monetary policy affect these factors in the long run? Explain.
“In the short run, shifts in monetary policy exert an impact on real output and employment. A shift to a more restrictive policy will tend to reduce real output and employment, while a shift to a more expansionary monetary policy will tend to increase them. However, if the more expansionary policy persists, the long-run impact will be inflation and higher nominal interest rates, without any positive impact on real output and employment. The more rapid the sustained growth rate of the money supply (relative to real output), the higher the expected rate of inflation. Thus, modern analysis indicates that the long-run implications of the earlier quantity theory of money are correct: Money growth and inflation are closely linked.” (Economics: Private and Public Choice, p.284) The money supply in an economy is the benchmark by which interest rates are determined. The supply of money is directly tied into the amount of money that can be loaned and borrowed in various capacities. The more money there is to loan, the less “expensive” it is to borrow that money. This is because when there is an increase in the money supply, the demand for that money fluctuates as well. This causes an increase in the overall amount of money being exchanged, and in turn, also causes a decrease in the real interest rate. The decrease in the interest rate also affects the economic appeal of domestically produced goods and services. This causes increased economic activity and the increase of real output because of that activity. When output increases, economic theory says that employers will typically need to hire more workers in order to handle their increased sales and output....
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