Question

You are asked to predict the economic future of a country with the following data: The long-run growth rate of potential output is 3% per year, velocity is constant, the money supply grows at a rate of 5% per year. Initially, actual output equals potential output. The nominal interest rate is 3.5%. Prices are sticky in the short run.

The central bank is considering an increase in the money supply growth rate to 7% per year. You are asked to advise them about the economic effects.

a. Determine the country’s initial inflation rate and real interest rate.

b. Predict the short-run impact of the central bank’s policy change on output, inflation, and real interest rate, and the nominal interest rate. Illustrate your answers with output/inflation and output/interest rate diagrams.

c. Predict the country’s inflation rate, real interest rate, and nominal interest rate in the long run, after the money growth rate has increased to 7%.

Answer 1

Ans. Growth rate of real output, Y = 3%

Growth rate in velocity of money, V = 0

Growth rate of money supply, M = 5%

Nominal interest rate, n = 3.5%

Inflation rate = p

Real interest rate = r

a) From Quantity theory of money,

M + V = p + Y

=> p = M - Y = 5 - 3 = 2%

and

r + 1 = (1+n)/(1+p) = 1.035/1.02 = 1.015

=> r = 0.015 or 1.5%

b) In short run, increase in money supply leads to an excess supply of money in money market leading to a decrease in interest rate from i to i’. Also, it shifts the LM curve rightwards from LM to LM’.This leads to a decrease in borrowing cost and thus, increase in consumption and investment. This leads to an increase in aggregate demand shifting the curve rightwards from AD to AD’. As aggregate supply has not chmaged, so, an increase in aggregate demand leads to an increase in price level from P to P’ and output from Y (Full employment level) to Y’.

c) In long run, output is back to the full employment level and real interest is also back to the initial level. So, the increase in money supply has lead to increase in price level only. So,

New inflation rate, p’ = New money growth - Y = 7 - 3 = 4%

New nominal interest rate = (1+r)(1+p’) -1 = (1.015*1.04) - 1 = 0.0556 or 5.56%

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