Question

Please show the “liquidity” and “income” effect in the expansionary monetary policy and discuss the volume of the liquidity effect arises depending on what? (show graphically)

Answer 1

Increasing money supply is an expansionary influence on the economy, it should raise national income and wealth. Both the liquidity preference and loanable funds frameworks indicate that interest rates will then rise. Thus the income effect of an increase in the money supply is a rise in interest rates in response to the higher level of income.

An increase in the money supply can also cause the overall price level in the economy to rise. The liquidity preference framework predicts that this will lead to a rise in interest rates.

The rising price level (the higher inflation rate) that results from an increase in the money supply also affects interest rates by affecting the expected inflation rate. Specifically, an increase in the money supply may lead people to expect a higher price level in the future—hence the expected inflation rate will be higher. The loanable funds framework has shown us that this increase in expected inflation will lead to a higher level of interest rates