Question

11. What are the short-run and long-run effects of monetary tightening on no minal interest rates? (Please justify)

Answer 1

Tightening monetary policy raises the federal funds rate by reducing the supply of money in the economy. It tends to shift the LM curve to its left from LM to LM1 which raise the rate of nominal interest from "i" to "i1" and reduce the level of output from "Y" to "Y1" in short run.

In long run, reduction in money supply will reduce the circulation of money in the economy which tends to reduce the spending power of consumers as they tends to spend more when they have more cash in hand. Reduction in money supply will lead to reduction in aggregate demand in the economy in long run which will reduce the price level from "P" to "P" and output level from "Y" to "Y1" in the economy.

Reduction in aggregate demand will shift the IS curve to its left from IS to IS1 in long run which will reduce the rate of interest to "i" again and take it to initial level as well as reduces level of output further to "Y2".