Question

1. Suppose that the money supply increases substantially. Explain what happens throughout the following steps.
2. a. Explain how the change in the interest rate affects international demand for Canadian financial assets. How does this then affect the exchange rate?
3. b. What effect does the change of the exchange rate have on net exports
4. c. How do the combined changes in consumption, investment, and net exports affect the AE curve and the AD curve
5. d. 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?
6. e. Based on your answers above, can expanding the money supply drive long-run growth? What is this relationship called?

Answer 1

a) An increase in money supply for a given money demand will put a downward pressure on the market interest rate. This will lead to fall in the demand for Canadian financial assets globally as now people get lower return due to fall in interest rate. This will lead to a low demand for Canadian dollar and thus, lead to depreciation of Canadian dollar.

b) Due to depreciation of currency, exports from Canada become cheaper for foreign countries, increasing their demand but imports to Canada become expensive, reducing their demand. Thus, exports increase and imports decrease. This leads to an improvement in the net exports component of the GDP.

c) Due to reduced interest rates, private investment increases and because now opportunity cost of consumption(interest on savings) has decreased, so, consumption will also increase. Thus, consumption, investment and net exports have increased , so, real GDP will increase in short run.

This will lead to an upward shift in AE curve and a rightward shift in AD curve because due to increased consumption,investment and net exports, aggregate expenditure will increase as aggregate demand for goods have increased.

d) There is positive output gap that exists now because now the real GDP is more than the potential level of GDP. But increased AD for given short run AS has also led to an increase in price level. If the potential GDP does not rise in long run then, due to increase price level the real income of labor will fall and they will start danding more income which will increase the cost of production. This will lead to a leftward shift of the short run AS curve till the point where increased output is back to potential level. But this will lead to increase in price level even further.

e) Thus, an increase in money supy won’t change the real GDP in long run but will only increase the price level. Thus, in long run change in nominal money supply has no impact on real variables like real GDP but only impact price level. This is called classical dichotomy.

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