Question

If the Central Bank changes the quantity of money, how do the interest rates change in the short-run and long-run ?

Answer 1

Consider the economy begins at potential output, Y1. The initial short-run aggregate supply curve is SRAS1, the long-run aggregate supply curve is LRAS, and the initial aggregate demand curve is AD1. The economy’s initial equilibrium is at E1, a point of both short-run and long-run macroeconomic equilibrium because it is on both the short-run and the long-run aggregate supply curves. Real GDP is at potential output, Y1.

Now suppose there is an increase in the money supply. Other things equal, an increase in the money supply reduces the interest rate, which increases investment spending, which leads to a further rise in consumer spending, and so on. So an increase in the money supply increases the number of goods and services demanded, shifting the AD curve rightward to AD2.

In the short run, the economy moves to a new short-run macroeconomic equilibrium at E2. The price level rises from P1 to P2, and real GDP rises from Y1 to Y2. That is, both the aggregate price level and aggregate output increase in the short run.

But the aggregate output level Y2 is above potential output. As a result, nominal wages will rise over time, causing the short-run aggregate supply curve to shift leftward. This process stops only when the SRAS curve ends up at SRAS2 and the economy ends up at point E3, a point of both short-run and long-run macroeconomic equilibrium.

The long-run effect of an increase in the money supply, then, is that the aggregate price level has increased from P1 to P3, but the aggregate output is back at potential output, Y1. In the long run, a monetary expansion raises the aggregate price level but has no effect on real GDP.