Question

Suppose an economy has been having very high inflation. The central bank has decided to decrease the money supply in hopes of decreasing GDP (the thinking is that by decreasing GDP, it will lead to lower inflation – no need to make that connection, just focus on the goal of decreasing GDP). Using the complete Keynesian model, explain in as much detail as possible what will likely happen to the economy (including GDP, the interest rate, investment spending, any multiplier effects). Finally, under what conditions would GDP be more effected (e.g., high or low mpc, steep or flat money demand, steep or flat investment schedule)?

Answer 1

Central bank have decided to decrease the money supply to reduce the level of GDP in the economy. Reduction in supply of money will shift LM curve to its left from LM to LM1 while IS remains the same, it raise the rate of interest from "i" to "i1" and reduce real GDP from Y to Y1. As interest rate falls, investment level will rise as it makes borrowing cheaper.

Due to fall in money supply in the economy, there would be less circulation of money in the economy which will reduce the willingness to pay for goods by people and result in fall in aggregate demand in the economy. It will reduce aggregate demand curve from AD to AD1 while supply remains the same. It results in fall in price level from P to P1 and output from Y to Y1. As price falls, inflation level falls in the economy.

Multiplier = [1 / (1 - MPC)]. The higher the MPC, the higher is the multiplier which will result in higher GDP.

The steeper the money demand, the lower the change in demand of money and higher the change in rate of interest with reduction in money supply. Higher interest rate will reduce the real GDP by reducing investment level.

The flatter the investment curve, the more is the fall in invetment due to rise in interest rate. As investment and aggregate demand are positively relatied, higher the fall in investment, higher is the fall in real GDP.