Question

Suppose that the National Bank of Georgia increases the money supply. How would that effect the prices and the real interest rate in the short run and in the long run? Illustrate your answer graphically.

Answer 1

As National Bank of Georgia is increasing the money supply, it will shift LM curve to its right while keep IS same.

It will reduce the rate of interest from "i" to "i1" and raise output level from "Y" to "Y1" in short run. A rise in money supply will raise money holding with people and tends to raise willingness to pay for goods which tends to raise aggregate demand in the economy. A rise in aggregate demand will shift aggregate demand curve to its right from AD to AD1 hwich will raise price level from P to P1 and raise output level from Y to Y1.

In long run, producers will invest more oney in the market as there is decrease in real interest rate which makes their borrowing cheaper. It will raise aggregate spending in the economy which shift IS curve to its right from IS to IS1 wchih will raise rate of interest again to its initial level while raising output level further to Y2.

As consumers are demanding more goods at higher price, producers will raise their supply of goods to earn more profit which will shift aggregate supply curve to its right in long run which will reduce price to its initial level while raise output level further.