Question

Develop a model to show how changes in the money supply can affect investment, income, unemployment and inflation.

Answer 1

(a) Money supply increases

Higher money supply reduces interest rate, which increases investment and increases aggregate demand. AD curve shifts rightward, increasing real GDP and income, increasing inflation and decreasing unemployment.

In following graph, MD0 and MS0 are initial money demand and supply functions intersecting at point A with initial interest rate r0 and quantity of money M0. As money supply rises, MS0 shifts right to MS1, intersecting MD0 at point B with lower interest rate r1 and higher quantity of money M1.

In following graph, AD0 and SRAS0 are initial aggregate demand and short run aggregate supply curves intersecting at point A with initial price level P0 and real GDP (income) Y0. As investment rises, AD0 shifts rightward to AD1, intersecting SRAS0 at point B with higher price level P1 and higher real GDP (income) Y1.

(b) Money supply decreases

Lower money supply raises interest rate, which decreases investment and decreases aggregate demand. AD curve shifts leftward, decreasing real GDP and income, decreasing inflation and increasing unemployment.

In following graph, MD0 and MS0 are initial money demand and supply functions intersecting at point A with initial interest rate r0 and quantity of money M0. As money supply falls, MS0 shifts left to MS1, intersecting MD0 at point B with higher interest rate r1 and lower quantity of money M1.

In following graph, AD0 and SRAS0 are initial aggregate demand and short run aggregate supply curves intersecting at point A with initial price level P0 and real GDP (income) Y0. As investment falls, AD0 shifts leftward to AD1, intersecting SRAS0 at point B with lower price level P1 and lower real GDP (income) Y1.