In the short run before the price level can adjust the real interest rate will fall from r 1 to r 2 and output and income fall from their full-employment levels to Y 1. As time passes the price level will fall, increasing the real money stock and shifting the LM curve down to LM'. Money demand: Money demand is the amount of money which people wants to hold as liquid assets like coins and notes. Money demand is a function of price level, level of output, interest rate. Based on this equation, holding the money velocity constant, if the money supply (M) increases at a faster rate than real economic output (Q), the price level (P) must increase to make up the difference.
- Decrease In Real Money Price Level Causes
- A Decrease In Real Money Balances Resulting From A Higher Price Level Will
18.9 Effects of a Money Supply Increase
Learning Objective
- Learn how a change in the money supply affects the equilibrium interest rate.
Expansionary monetary policyAn increase in the money supply in a country. refers to any policy initiative by a country’s central bank to raise (or expand) its money supply. This can be accomplished with open market purchases of government bonds, with a decrease in the reserve requirement, or with an announced decrease in the discount rate. In most growing economies the money supply is expanded regularly to keep up with the expansion of gross domestic product (GDP). In this dynamic context, expansionary monetary policy can mean an increase in the rate of growth of the money supply, rather than a mere increase in money. However, the money market model is a nondynamic (or static) model, so we cannot easily incorporate money supply growth rates. Nonetheless, we can project the results from this static model to the dynamic world without much loss of relevance. (In contrast, any decrease in the money supply or decrease in the growth rate of the money supply is referred to as contractionary monetary policy.)
Suppose the money market is originally in equilibrium in Figure 18.3 'Effects of a Money Supply Increase' at point A with real money supply MS′/P$ and interest rate i$′ when the money supply increases, ceteris paribus. The ceteris paribus assumption means we assume that all other exogenous variables in the model remain fixed at their original levels. In this exercise, it means that real GDP (Y$) and the price level (P$) remain fixed. An increase in the money supply (MS) causes an increase in the real money supply (MS/P$) since P$ remains constant. In the diagram, this is shown as a rightward shift from MS′/P$ to MS″/P$. At the original interest rate, real money supply has risen to level 2 along the horizontal axis while real money demand remains at level 1. This means that money supply exceeds money demand, and the actual interest rate is higher than the equilibrium rate. Adjustment to the lower interest rate will follow the “interest rate too high” equilibrium story.
The final equilibrium will occur at point B on the diagram. The real money supply will have risen from level 1 to 2 while the equilibrium interest rate has fallen from i$′ to i$″. Thus expansionary monetary policy (i.e., an increase in the money supply) will cause a decrease in average interest rates in an economy. In contrast, contractionary monetary policy (a decrease in the money supply) will cause an increase in average interest rates in an economy.
Note this result represents the short-run effect of a money supply increase. The short run is the time before the money supply can affect the price level in the economy. In Chapter 18 'Interest Rate Determination', Section 18.14 'Money Supply and Long-Run Prices', we consider the long-run effects of a money supply increase. In the long run, money supply changes can affect the price level in the economy. In the previous exercise, since the price level remained fixed (i.e., subject to the ceteris paribus assumption) when the money supply was increased, this exercise provides the short-run result.
Key Takeaway
- An increase (decrease) in the money supply, ceteris paribus, will cause a decrease (increase) in average interest rates in an economy.
Exercise
Jeopardy Questions. As in the popular television game show, you are given an answer to a question and you must respond with the question. For example, if the answer is “a tax on imports,” then the correct question is “What is a tariff?”
- Term often used to describe the type of monetary policy that results in a reduction of the money supply.
- Term often used to describe the type of monetary policy that results in an increase in the money supply.
- Of increase, decrease, or stay the same, the effect on the equilibrium interest rate when the nominal money supply increases, ceteris paribus.
- Of increase, decrease, or stay the same, the effect on the equilibrium interest rate when the nominal money supply decreases, ceteris paribus.
- Term for the time period before price level changes occur in the money market model.
The below mentioned article provides an overview on the value of money and the price level.
Subject Matter:
The average level of all prices in a country is called the price level. There are thousands of waves in a sea, each wave having a different height.
Nevertheless, we can calculate the average level of the sea and call it the sea- level. Similarly, we can calculate the price level, although there are thousands of prices, all moving in different ways.
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When the price level rises money can buy less goods and services. So we say that its purchasing power has fallen. Conversely, when the price level falls, money can buy more and we can say its purchasing power has gone up. Thus, the value of money changes inversely with the price level. In our country, the price level increased by about 400% during World War n (1939-1945). The value of the rupee fell by the same percentage.
Why Does the Price Level Change?
Changes in the price level are caused by two factors:
(a) changes in the supply of money, and
(b) changes in the supply of goods and services.
When the quantity of money in circulation in a country is increased (e.g., by printing new notes) more money is available to the people for making purchases, the demand for goods and services goes up and the price level tends to rise.
Conversely, if the supply of money decreases people can buy less and the price level tends to go down. Again, if there is an increase in the supply of goods and services, the price level tends to fall and, in the converse case, it tends to rise.
Thus, if the supply of money increases by 25% and the supply of goods and services also increases by the same 25%, there will ordinarily be no effect on the price level. There are other factors which influence the price level (e.g., the number of times money changes hands or the velocity of circulation) but the first two factors are the most important of all.
In India, during World War II, there was a large increase in the volume of notes printed by the Government. There was, at the same time, a decrease in the supply of goods (due to reduction of imports, etc.). Consequently, the price level increased many times.
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It is possible to analyse the causes of price changes in a different way. Modern writers believe that price level changes are brought about by changes in the level of income, i.e., the average amount of money earned by that people when more income is earned, the demand for the goods and services goes up and price rise. When income falls, less goods and services are demanded and price fall. [Changes in the level of income depend on two factors, the volume of savings and the volume of investment in the country.]
The Inflation Machine:
When inflation is reduced to its simplest elements, its proximate causes can easily be identified. Figure 19.1 represents the inflation machine. Let us assume for a moment that the value of the consumable goods and services produced is in balance with the money paid to all those who compete for the purchase of the goods and services.
Then prices will remain unchanged. Of course, prices of individual items will fluctuate due to changes in demand and supply conditions, but the aggregate price level will be stable. In fact, the inflation machine is nothing more than or less than a broad view of supply and demand and the market clearing price.
Now, if we load the left hand side of the inflation machine with more money than the value of goods and services on the right side, prices will surely increase. Competition for the limited amount of goods that is available will rare prices. Another way to load the left hand side of the inflation machine is for the same number of rupees to be spent with greater frequency. This is called increasing the velocity of money.
Decrease In Real Money Price Level Causes
The rupees flow through the economic system faster and this creates a similar effect. Alternatively, if people take money out of savings and spend it, that increases the number of rupees in competition for the available goods. The effect is the same—competition for what is available on the right side will drive prices up.