Question

Based on the Keynesian model, analyze the effects of an increase in the money supply on the level of real income, the price level, the money wage and the interest rates. 10 markhs

Answer 1

In Macroeconomics or Monetary/Financial Economics, an increase in the money supply by the Central Bank in any country basically constitutes an expansionary monetary policy which is widely and most commonly used as a remedial mechanism to stimulate or stabilize the overall economy, especially during or following any economic downturn or recessionary phase in the business cycle. Now, based on the Keynesian Model, an expansionary monetary or increase in the money supply in the economy would primarily induce higher supply and quantity of loanable funds in the money market, holding everything else constant. The availability of more or higher loanable funds or money in the economy would further stimulate the aggregate consumption expenditure or spending thereby, increasing the aggregate demand(AD) in the goods market in the economy as now, the individual consumers and household units in the economy have more money or loanable funds to spend on or finance various consumption activities which would reduce the aggregate or overall savings and enhance the overall or aggregate consumption expenditure. An expansionary monetary policy would also eventually reduce the interest rate in the economy thereby, encouraging the private firms, companies, or business organizations to undertake more financial loans or increase financial borrowings to finance various present and potential business or commercial investment projects as the interest payments on any financial or investment borrowings would now become relatively less. This would also essentially contribute to an increase in AD through increase in the aggregate investment level in the economy. Lower interest rate would also encourage consumers and household units to undertake financial loans and borrowings to finance large-scale consumption expenditures.Therefore, from an overall point of view, an increase in AD in the goods market would lead to an increase in both real output or real income and the overall price level of goods and services causing inflationary effects in the economy, again holding everything else constant or unchanged such as short-run and /or long-run aggregate supply or SRAS and/or LRAS. As the aggregate investment level in the economy has increased due to lower nominal interest rate attributable to expansionary monetary policy, the firms or companies would have a high demand for various factors or inputs of production such as labor, land, physical or capital inputs, etc. to undertake further investment and production plans. Therefore, higher labor demand in the labor market by the firms or companies would increase the money wage, considering all the other relevant factors and determinants as constant.