Chapter 1. Chapter 15A (30A)

In the short run, the interest rate is determined in the money market:the short-run equilibrium interest rate is determined where money demand equals money supply. An increase in the money supply will lead to a fall in the interest rate in the money market. The fall in the interest rate will lead to an increase in real GDP, followed by an increase in savings through the multiplier process. The increase in savings will increase the supply of loan able funds, leading to a fall in the interest rate in the loan able funds market as well. Therefore, in the short run an expansionary monetary policy will increase real GDP; similarly, a contradictory monetary policy will reduce real GDP in the short run. In the long run, real GDP cannot differ from potential output. So in the long run, the interest rate is determined in the loan able funds market: the long-run equilibrium interest rate equalizes the supply of loan able funds and the demand for loan- able funds that arise when aggregate output is equal to potential output. In the long run an increase in the money supply will ultimately result in an increase in nominal wages. The short-run aggregate supply curve will shift leftward and real GDP will fall. As real GDP falls, savings will fall as well, leading to a reduction in the supply of loan able funds and a rise in the interest rate. This process will continue until aggregate output is equal to potential output. The interest rate in the money market will also rise, as a higher aggregate price level in the long run leads to an increase in the nominal demand for money. Therefore, in the long run the Fed cannot influence the interest rate and monetary policy will have no effect on real GDP.

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