Question

How does an increase or decrease in money supply (specifically as a result of overnight rate fluctuation) effect income, price level, and interest rate?

Answer 1

Change in the money supply influences the key rates of interest in the economy. When money supply is increased, there is an increase in the amount of reserves in the banking system. depository institutions attempt to use these reserves in generation of loans by offering lower rate of interest to borrowers. Borrowers used these loans both for investment as well as for consumption purposes. As the investment and consumption is increased aggregate demand is increased. in the goods market we can expect the aggregate demand curve to shift to the right and increasing the price level and real GDP in the short run. because it is a demand pull inflation it is expected that employment is increased when firms start producing and therefore unemployment decreases.

similarly a decrease in the money supply is likely to decrease the output and income by increasing the rate of interest. It helps in bringing down the rate of inflation.