The interest rate is 5 percent initially. Now the Money Supply increases and the interest rate...

The interest rate is 5 percent initially. Now the Money Supply increases and the interest rate declines to 3.5 percent in the short run. Let us assume two scenarios. In the first scenario, the interest rate ends up at 4 percent in the long run, but in the second scenario it ends up at 6 percent in the long run. State what we are assuming about the liquidity effect (LE), income effect (IE), price level effect (PLE), and the expected inflation effect (EIE) for each scenario.

Expert Solution

LE (LIQUIDITY EFFET)

An exogenous increase in the money supply is typically followed by a temporary fall in nominal interest rates. ... In macroeconomics, the term liquidity effect refers to a fall in nominal interest rates following an exogenous persistent increase in narrow measures of the money supply.

In first scenario the LE is decreasing slightly while in second scenario the LE is decreasing as the interest rate is currently 3.5%

(PLE) As the price level rises the purchasing power of your money ill decline, so people will carry more money to buy the same thing. Therefore, people will demand more money, then interest rate will increase and both businesses and households will spend less. Hence, Aggregate demand will decrease.

Therefore price level effect will increase in both the scenarios as price level effect is directly proptional to interest rates

EXPECTED INFLANATION RATE

Importance in Money Supply

The Fisher effect is more than just an equation: It shows how the money supply affects nominal interest rate and inflation rate as a tandem. For example, if a change in a central bank's monetary policy would push the country's inflation rate to rise by 10 percentage points, then the nominal interest rate of the same economy would follow suit and increase by 10 percentage points as well. In this light, it may be assumed that a change in money supply will not affect the real interest rate. It will, however, directly reflect changes in the nominal interest rate.

Income effect

This movement is known as the substitution effect. However, assuming that present and future consumption are both normal goods, an increase in the interest rate will increase relative income leading to what is known as the income effect. Hence income effect would increase in both scenarios

Rahul Sunny answered 2 years ago

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