Suppose an economy is in long-run equilibrium. The central bank raises the money
ID: 1244620 • Letter: S
Question
Suppose an economy is in long-run equilibrium. The central bank raises the money supply by 5 percent. 1. What happens to output and the price level as the economy moves from the initial to the new short-run equilibrium. 2. What causes the economy to move from point B to point C? 3. According to the sticky-wage theory of aggregate supply, how do nominal wages at point A compare to nominal wages at point B? 4. According to the sticky-wage theory of aggregate supply, how do nominal wages at point A compare to nominal wages at point C? 5. According to the sticky-wage theory of aggregate supply, how do real wages at point A compare to real wages at point B? 6. According to the sticky-wage theory of aggregate supply, how do real wages at point A compare to real wages at point C? 7. Judging by the impact of the money supply on nominal and real wages, is this analysis consistent with the proposition that money has real effects in the short run but is neutral in the long run?Explanation / Answer
t is important to distinguish the cause and effect of the two variables - you are asking why a decrease in money supply leads to an increase in interest rates, and the replies have so far been telling you why an increase in interest rates leads to a decrease in money supply. So, can you change the money supply to have an effect on interest rates? Yes. Let's see what happens. First, you have a decrease in money supply. This is usually the result of a central bank policy (although we shall not go into how exactly they do this - might be confusing). Assuming that we are in the short run, prices are given (i.e. do not change) and money demand remains the same. Now, there is a disequilibrium in the money market, where money demand is greater than money supply. Keeping that in mind, we now look at the initial equilibrium interest rate, r*. Now, at this current interest rate, people are holding less money than they desire, so they sell their assets (that pay interests) to have greater liquidity. However, as we have mentioned earlier, money demand is greater than money supply, there will be more people wanting to sell assets to obtain liquidity than people willing to buy assets and giving up liquidity. As a result, the interest rates get pushed up slowly, so as to reflect the market mechanism of creating a greater incentive for people to hold on to / buy assets. The interest rate will then rise to a point where there are equal number of assets being bought / sold. At this same point, money demand would also have decreased to match the lower money supply. Hope that helps, and let me know if it doesn't. It probably means I wasn't clear enough.