Question

a)How is Money Supply controlled? What is the relationship between money and inflation?

b)Use the money market to explain the interest-rate effect and its relation to the slope of the aggregate demand curve.

Answer 1

a) money supply is controlled by the central bank, federal reserve bank. When more money is needed in the market central bank prints more money and when less money is needed in the market central bank reduces supply of money.

There is a positive relationship between money supply and inflation. When money supply increases aggregate demand increases but since there is no change in aggregate supply, price level increases.

b) we know that demand for money depends on the price level. Lower the price lower is the money demanded because less money is needed to buy goods. Lower demand for money implies that consumers deposit money in bank accounts. When money in bank increases, supply of loan increases. This reduces the cost of loan that is interest rate. Lower interest rate further leads to increase in demand for investment. Increase in investment increases aggregate demand. Therefore lower price level lowers interest rate which increases aggregate demand or slope of aggregate demand is negative. Lower the price higher is aggregate demand.