Supply and Demand in the market for the money

1 income effect because an increasing money supply is

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Unformatted text preview: xpansionary influence on the economy, it should raise national income and wealth. Both the liquidity preference and loanable funds frameworks indicate that interest rates will then rise (see Figure 2). Thus the income effect of an increase in the money supply is a rise in interest rates in response to the higher level of income. 2. Price-level effect. An increase in the money supply can also cause the overall price level in the economy to rise. The liquidity preference framework predicts that this will lead to a rise in interest rates. So the price-level effect from an increase in the money supply is a rise in interest rates in response to the rise in the price level. 3. Expected-inflation effect. The rising price level (the higher inflation rate) that results from an increase in the money supply also affects interest rates by affecting the expected inflation rate. Specifically, an increase in the money supply may lead people to expect a higher price level in the future—hence the expected inflation rate will be higher. The loanable funds framework has shown us that this increase in expected inflation will lead to a higher level of interest rates. Therefore, the expected-inflation effect of an increase in the money supply is a rise in interest rates in response to the rise in the expected inflation rate. At first glance it might appear that the price-level effect and the expected-inflation effect are the same thing. They both indicate that increases in the price level induced by an increase in the money supply will raise interest rates. However, there Supply and Demand in the Market for Money: The Liquidity Preference Framework W-37 is a subtle difference between the two, and this is why they are discussed as two separate effects. Suppose that there is a onetime increase in the money supply today that leads to a rise in prices to a permanently higher level by next year. As the price level rises over the course of this year, the interest rate will rise via the price-level effect. Only at the end of the year, when the price level has risen to its peak, will the price-level effect be at a maximum. The rising price level will also raise interest rates via the expected-inflation effect because people will expect that inflation will be higher over the course of the year. However, when the price level stops rising next year, inflation and the expected inflation rate will fall back down to zero. Any rise in interest rates as a result of the earlier rise in expected inflation will then be reversed. We thus see that in contrast to the price-level effect, which reaches its greatest impact next year, the expected-inflation effect will have its smallest impact (zero impact) next year. The basic difference between the two effects, then, is that the price-level effect remains even after prices have stopped rising, whereas the expected-inflation effect disappears. An important point is that the expected-inflation effect will persist only as long as the price level continues to rise. A onetime increase in the money supply will not produce a con...
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This note was uploaded on 01/02/2013 for the course ECON 102 taught by Professor Lisa during the Spring '09 term at RMIT Vietnam.

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