Question

1. Suppose that the money supply increases substantially. Explain what happens throughout the following steps.

   Suppose that prior to the increase in the money supply, equilibrium GDP was equal to potential GDP. What type of output gap now exists? If potential GDP does not increase, what will happen to equilibrium GDP in the long run?

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   Based on your answers above, can expanding the money supply drive long-run growth? What is this relationship called?

Answer 1

The primary effects of an increase in money supply is that is reduces interest rate, increases investment spending(more investments become profitable due to lower interests), This leads to an upward shift in AD i.e AD increases. With a substantial increase in money supply, a substantial rise in investments creates multiplier effect through consumption and goverment purchases. Thus a larger positive effect on AD which drives prices to rise.This is the very short run and short run effect.

Now since the equilirium GDP is at its potential, this means that the economy is running at its full capacity. With a substantial increase in money supply, AD rises substantially and this drives the prices up in the short run. Ths price rise is because resources are used over their capacity and there is a upward pressure on the prices. Thus AD rises and the overall price level. Now there is a gap in the potential GDP and actual GDP (expenditure). This gap is called the inflationary gap.

Potential GDP can be lower than actual GDP in short run. In the long run the economy is fixed at its potential. However if potential gdp doesnt increase (due to a disaster which has reduced work force, destroyed capital and technology), the long run supply curve can shift leftward (LRAS is vertical and a case of a fall in potential GDP is not likely) and can create recession and even stagflation. Hence decreasing equilibrium GDP.

However in the long run, there is self adjustment in the economy. and With a rise in prce, real wage rates fall (nominal wages are sticky when gdp is at or above full potential), thus decreasing purchasing power. This shifts the labour supply negatively and the new short run aggregate supply will shift. This mechanism will continue until actual gdp again returns to the potential gdp.

Given that there is no natural calamity, The actual gdp will always go back to its natural rate (potential gdp) in the long run. From this discussion its clear that increasing money suppy can increase induce increased long run growth at the cost of rising prices in the short run. This policy is known as a expansionary monetary policy and the relation is called Monetarism (believe than increased money supply drives long run growth).