How monetary policy can raise the level of aggregate demand
in the short run.
Monetary policy is the process by which the monetary authority of a country controls the supply of money, usually targeting a rate of the interest for the purpose of promoting economic grown and stability. ( Wikipedia ) In the short run, monetary policy affects the lever of output as its compositions can also affects the lever of output. An increase in money leads to a decrease in interest rates and a depreciation of the currency. Both of them can lead to an increase in the demand for goods and an increase in output.(Blanchard, 2009) There are two different ways of monetary policy, an increase in money supply is called monetary expansion and a decrease in the money supply is called monetary contraction. This essay express how monetary policy can rise the lever of aggregate demand in the short run based on money supply, interest rate, income and bond price.
The relation between the nominal income and demand
As we know thar the relation between the demand for money, nominal income and the interest rate is: Md =$Y L(i)
that means the interest rate has a negative effect on money, an decrease in the interest rate increases the demand for money. In other words, the demand for money increases in proportion to nominal income, and the demand for money depends negatively on the interest rate.
According to the Figure1, the initial equilibrium is at point A. As increase in nominal income from $Y to $Y', increasing the level of transactions, which increases the demand for money at any interest rate. The money demand curve shifts from left to the right(Md to Md') the new equilibrium moves from A up to A', and the equilibrium interest rate increases from i to i'. [pic]
Figure 1: The effects of an Increase in Nominal Income on the Interest Rate. Source: Adapted form Blanchard 2009
Thus, an increase in nominal income can raise the level of demand for money in...
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