Question
If the price level is fixed,increment of money supply will increase real money balance and decrease the equilbrium interest rate.graphically dipict and discuss.
Answers
GPT-4o mini
When the price level is fixed, an increase in the money supply affects the real money balance in the economy, leading to a decrease in the equilibrium interest rate. This concept can be illustrated using the money market model, which shows the relationship between the money supply, money demand, and the interest rate.
### Graphical Representation
1. **Axes**:
- The vertical axis represents the interest rate (i).
- The horizontal axis represents the quantity of money (M).
2. **Curves**:
- **Money Supply (MS)**: This is a vertical line because the money supply is fixed by the central bank (assuming it does not change the supply of money).
- **Money Demand (MD)**: This is a downward-sloping curve, reflecting that at lower interest rates, the quantity of money demanded increases (people are more willing to hold money at lower interest rates).
3. **Initial Equilibrium**:
- The intersection of the MS and MD curves determines the initial equilibrium interest rate (i₁) and the initial quantity of money (M₀).
4. **Increase in Money Supply**:
- When the money supply increases (for example, due to monetary policy actions by the central bank), the money supply curve shifts to the right (MS shifts from MS₀ to MS₁).
5. **New Equilibrium**:
- The new intersection point between the new money supply curve (MS₁) and the money demand curve (MD) occurs at a lower interest rate (i₂), resulting in an increase in the quantity of money (M₁).
### Discussion
#### Mechanism:
1. **Increase in Real Money Balances**:
- Real money balances are calculated as the nominal money supply divided by the price level. With a fixed price level, an increase in the nominal money supply directly increases real money balances.
2. **Decrease in Interest Rates**:
- As real money balances rise, people have more money than they want to hold at the existing interest rate. To adjust, they will tend to spend or lend out the excess money, increasing the supply of loanable funds in the economy.
- This increase in the supply of funds leads to a decrease in the interest rate, as lenders compete to offer loans by lowering the cost of borrowing.
3. **Implications**:
- A decrease in the equilibrium interest rate can stimulate investment and consumption. Lower interest rates reduce the cost of borrowing for consumers and businesses, potentially leading to economic growth.
### Conclusion
In summary, an increase in the money supply in a fixed price level environment increases real money balances, which drives interest rates down. This concept is crucial for understanding how monetary policy can influence economic activity through changes in interest rates.
### Graphical Representation
1. **Axes**:
- The vertical axis represents the interest rate (i).
- The horizontal axis represents the quantity of money (M).
2. **Curves**:
- **Money Supply (MS)**: This is a vertical line because the money supply is fixed by the central bank (assuming it does not change the supply of money).
- **Money Demand (MD)**: This is a downward-sloping curve, reflecting that at lower interest rates, the quantity of money demanded increases (people are more willing to hold money at lower interest rates).
3. **Initial Equilibrium**:
- The intersection of the MS and MD curves determines the initial equilibrium interest rate (i₁) and the initial quantity of money (M₀).
4. **Increase in Money Supply**:
- When the money supply increases (for example, due to monetary policy actions by the central bank), the money supply curve shifts to the right (MS shifts from MS₀ to MS₁).
5. **New Equilibrium**:
- The new intersection point between the new money supply curve (MS₁) and the money demand curve (MD) occurs at a lower interest rate (i₂), resulting in an increase in the quantity of money (M₁).
### Discussion
#### Mechanism:
1. **Increase in Real Money Balances**:
- Real money balances are calculated as the nominal money supply divided by the price level. With a fixed price level, an increase in the nominal money supply directly increases real money balances.
2. **Decrease in Interest Rates**:
- As real money balances rise, people have more money than they want to hold at the existing interest rate. To adjust, they will tend to spend or lend out the excess money, increasing the supply of loanable funds in the economy.
- This increase in the supply of funds leads to a decrease in the interest rate, as lenders compete to offer loans by lowering the cost of borrowing.
3. **Implications**:
- A decrease in the equilibrium interest rate can stimulate investment and consumption. Lower interest rates reduce the cost of borrowing for consumers and businesses, potentially leading to economic growth.
### Conclusion
In summary, an increase in the money supply in a fixed price level environment increases real money balances, which drives interest rates down. This concept is crucial for understanding how monetary policy can influence economic activity through changes in interest rates.