Problem Set 5
1. What impact will an unanticipated increase in the money supply have on the real interest rate, real output, and employment in the short run? How will expansionary monetary policy affect these factors in the long run? Explain.
The money supply in an economy is the benchmark by which interest rates are determined. The supply of money is directly tied into the amount of money that can be loaned and borrowed in various capacities. The more money there is to loan, the less “expensive” it is to borrow that money. This is because when there is an increase in the money supply, the demand for that money fluctuates as well. This causes an increase in the overall amount of money being exchanged, and in turn, also causes a decrease in the real interest rate. The decrease in the interest rate also affects the economic appeal of domestically produced goods and services. This causes increased economic activity and the increase of real output because of that activity. When output increases, economic theory says that employers will typically need to hire more workers in order to handle their increased sales and output. However, this may not be the case in todays modern economy because modern businesses’ potential output are not directly proportional to their workforce. The long run economic impact depends on whether or not the unexpected short run money supply increase is permanent or not. If the money supply increase is permanent, then the short run effects mentioned above will drive the output of the economy above where it naturally should be. If the Fed decided to implement an Expansionary monetary policy to counteract this increase in the money supply then it would most likely try to reduce interest rates. This type of monetary stimulus affects the interest rates in the short term. This can eventually lead to long term economic change based on short term economic change being as the Fed intended. Expansionary policies are meant to push