Explain using the equation for aggregate demand what happens when the Federal Reserve increases the money supply.

Solutions

Expert Solution

Aggregate Demand is the sum of consumption expenditure, investment spending, government expenditure, and net export.

It can be represented as:

AD = C(Y) + I(r) + G + (X - M).

C(Y) is a consumption function which shows consumption is a function of Y.

I(r) is an investment function which shows investment is a function of interest rate.

G is government expenditure.

X-M is export minus import or net export.

Expansionary monetary policy has two effects, It changes the interest rate and money in the economy.

Now when money supply increases, the money in the economy will increase now there is more money in the hand of people as income of consumer will increase which leads to an increase in consumption. Also, the increase in the money supply will decrease the interest rate in the economy. And investment is inversely related to the interest rate.

I = A - br

So when interest rate decrease, the investment will increase.

Now recall the equation of AD,

AD = C(Y) + I(r) + G + (X - M).

So when Consumption and investment increase, Aggregate demand will increase.

Junaid answered 1 year ago

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