Question

In detail, describe the money supply function and how it characterizes the interaction of three economic agents (players) in determining the behavior of money supply (Hint: an equation is

helpful here.)

Answer 1

Money supply function = (M/P) = kY - Hi, where M is the total quantity of money supplied, P is the general price level of commodities in the economy, i is the interest rate, and Y is income level.

Three economic agents are Central Bank, Consumers, and Producers.

As the price level in the economy increases, the value of real money reduces, which leads to increased interest rates at given levels of income.

When income increases and other variables remain constant, the amount of real money in the economy increases which leads to reduced interest rate and thus increased output levels.

When interest increases and other variables remain constant, the quantity of real money reduces and thus leading to reduced output levels as well

This is usually illustrated with a LM curve, which is upward sloping. An increase in money supply shifts the LM curve to the down to the right at given interest rates, while reduced money supply shifts it up to the left.