Question

What happens to expected inflation, nominal interest rate and real money demand when there is a permanent decrease in money supply growth?

Answer 1

Under IS-LM framework, the money market clears where the demand for money equals the supply of money. The real demand for money is , where is demand for real money L is the real demand for money function, Y is real output, and i is nominal interest rate. The equation can hence be written as , where r is the real interest rate and pi-e is expected inflation. The money market clears where real money demand equals real moeny supply, and for M be nominal money supply, the equilibrium will be where or .

As can be seen, the demand for money function is directly proportional to the money supply, as we have . Hence, decrease in money supply growth will either decrease P, or will decrease L. Assuming ceteris paribus, the decrease in M will decrease L. Now, L being the demand for money function, is positively related to Y, but inversely related to i. Hence, a decrease in growth of money supply, would decrease in gowth of real money demand, and that would lead to decrease in growth of output Y and/or increase in growth of i - the nominal interest rate. An increase in growth of nominal interest rate would either be related to increase in real interest rate - r, and/or increase in expected inflation .