18.10 Effect of a Price Level Increase (Inflation) on Interest Rates

How Does Increase In Money Supply Affect Interest Rates
How Does Increase In Money Supply Affect Real Interest Rates Will
Money Supply And Interest Rate Relationship
How Does Increase In Money Supply Affect Real Interest Rates Among

Learning Objective

Learn how a change in the price level affects the equilibrium interest rate.

Now let’s consider the effects of a price level increase in the money market. When the price level rises in an economy, the average price of all goods and services sold is increasing. Inflation is calculated as the percentage increase in a country’s price level over some period, usually a year. This means that in the period during which the price level increases, inflation is occurring. Thus studying the effects of a price level increase is the same as studying the effects of inflation.

Inflation can arise for several reasons that will be discussed later in this chapter. For now, we will imagine that the price level increases for some unspecified reason and consider the consequences.

Suppose the money market is originally in equilibrium at point A in Figure 18.4 'Effects of a Price Level Increase' with real money supply M^S/P_$′ and interest rate i_$′. Suppose the price level increases, ceteris paribus. Again, the ceteris paribus assumption means that we assume all other exogenous variables in the model remain fixed at their original levels. In this exercise, it means that the money supply (M^S) and real GDP (Y_$) remain fixed. An increase in the price level (P_$) causes a decrease in the real money supply (M^S/P_$) since M^S remains constant. In the adjoining diagram, this is shown as a shift from M^S/P_$′ to M^S/P_$″. At the original interest rate, i_$′, the real money supply has fallen to level 2 along the horizontal axis, while real money demand remains at level 1. This means that money demand exceeds money supply and the actual interest rate is lower than the new equilibrium rate. Adjustment to the higher interest rate will follow the “interest rate too low” equilibrium story.

More intuition concerning these effects arises if one recalls that price level increases will increase the transactions demand for money. In this version, nominal money demand will exceed nominal money supply and set off the same adjustment process described in the previous paragraph.

When the interest rates will be high, people would prefer to save than keeping cash in hand. It means money supply in the economy is decreased. And, when the interest rates will be low, then people prefer to keep cash in hand and spend i.e. Also, if you increased the money supply, (through a Central Bank creating more money), then this reduces interest rates. Higher money supply puts downward pressure on interest rates. Lower interest rates will also tend to reduce the value of the currency. The fall in the interest rate generated by excess supply of money will affect desired I =f(r). The fall in real income F generated by S I (desired) in the goods sector will affect the demand for money, which is a function of real Y only. As the interest rate falls, desired I rises, reducing S I (desired). (1) In IS-LM type models an exogenous increase in the money supply will decrease the interest rate. (2) IS-LM macro is like 1000 years old. Today central banks set the interest rate and the supply of cash provided by banks is largely endogenous. Most people would still agree that lower interest rates increase the supply of money, all else equal.

The final equilibrium will occur at point B on the diagram. The real money supply will have fallen from level 1 to level 2 while the equilibrium interest rate has risen from i_$′ to i_$″. Thus an increase in the price level (i.e., inflation) will cause an increase in average interest rates in an economy. In contrast, a decrease in the price level (deflation) will cause a decrease in average interest rates in an economy.

Key Takeaway

An increase in the price level (i.e., inflation), ceteris paribus, will cause an increase in average interest rates in an economy. In contrast, a decrease in the price level (deflation), ceteris paribus, will cause a decrease 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?”
1. The term used to describe a percentage increase in a country’s price level over a period of time.
2. Of increase, decrease, or stay the same, the effect on the equilibrium interest rate when the domestic price level decreases, ceteris paribus.
3. Of increase, decrease, or stay the same, the effect on the equilibrium interest rate when the domestic price level increases, ceteris paribus.

The Impact of Monetary Policy on Aggregate Demand, Prices, and Real GDP

Changes in a country’s money supply shifts the country’s aggregate demand curve.

Learning Objectives

Recognize the impact of monetary policy on aggregate demand

Key Takeaways

Key Points

Aggregate demand (AD) is the sum of consumer spending, government spending, investment, and net exports.
The AD curve assumes that money supply is fixed.
The decrease in the money supply is mirrored by an equal decrease in the nominal output, otherwise known as Gross Domestic Product ( GDP ).
The decrease in the money supply will lead to a decrease in consumer spending. This decrease will shift the AD curve to the left.
The increase in the money supply is mirrored by an equal increase in nominal output, or Gross Domestic Product (GDP).
The increase in the money supply will lead to an increase in consumer spending. This increase will shift the AD curve to the right.
Increased money supply causes reduction in interest rates and further spending and therefore an increase in AD.

Key Terms

aggregate demand: The the total demand for final goods and services in the economy at a given time and price level.

Aggregate demand (AD) is the total demand for final goods and services in the economy at a given time and price level. It is the combination of consumer spending, investments, government spending, and net exports within a given economic system (often written out as AD = C + I + G + nX). As a result of this, increases in overall capital within an economy impacts the aggregate spending and/or investment. This creates a relationship between monetary policy and aggregate demand.

This brings us to the aggregate demand curve. It specifies the amounts of goods and services that will be purchased at all possible price levels. This is the demand for the gross domestic product of a country. It is also referred to as the effective demand.

The aggregate demand curve illustrates the relationship between two factors – the quantity of output that is demanded and the aggregated price level. Another way of defining aggregate demand is as the sum of consumer spending, government spending, investment, and net exports. The aggregate demand curve assumes that money supply is fixed. Altering the money supply impacts where the aggregate demand curve is plotted.

Contractionary Monetary Policy

Contractionary monetary policy decreases the money supply in an economy. The decrease in the money supply is mirrored by an equal decrease in the nominal output, otherwise known as Gross Domestic Product (GDP). In addition, the decrease in the money supply will lead to a decrease in consumer spending. This decrease will shift the aggregate demand curve to the left. This reduction in money supply reduces price levels and real output, as there is less capital available in the economic system.

Aggregate Demand Graph: This graph shows the effect of expansionary monetary policy,

How Does Increase In Money Supply Affect Real Interest Rates