Suppose the economy begins in long-run macroeconomic equilibrium. What is the long-run effect on the aggregate price level of a 5% increase in the money supply? Explain.
A 5% increase in the money supply will cause a 5% increase in the aggregate price level in the long run. The process begins in the short run, when the larger money supply decreases the interest rate and promotes investment spending. Investment spending is a component of aggregate demand, so the increase in investment spending leads to an increase in aggregate demand, which causes real GDP to increase beyond potential output. The resulting upward pressure on nominal wages and other input prices shifts aggregate supply to the left until a new long-run equilibrium is reached. Although real GDP returns to its original level, both the increase in aggregate demand and the decrease in aggregate supply cause the aggregate price level to increase. The end result is 5% more money being spent on the same quantity of goods and services, which could only mean a 5% increase in the aggregate price level.
Question
Suppose the economy begins in long-run macroeconomic equilibrium. What is the long-run effect on the interest rate of a 5% increase in the money supply? Explain.
A 5% increase in the money supply will have no effect on the interest rate in the long run. As explained in the previous answer, a 5% increase in the money supply is matched by a 5% increase in the aggregate price level in the long run. Changes in the aggregate price level, in turn, cause proportional changes in the demand for money. Thus, a 5% increase in the aggregate price level increases the quantity of money demanded at any given interest rate by 5%. This means that at the initial interest rate, the quantity of money demanded rises exactly as much as the money supply, and the new, long-run interest rate is therefore no different from the initial interest rate.