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Unformatted text preview: tinually rising price level; only a higher rate of money supply growth
will. Thus a higher rate of money supply growth is needed if the expected-inflation
effect is to persist. Does a Higher Rate of Growth of the Money
Supply Lower Interest Rates?
We can now put together all the effects we have discussed to help us decide whether
our analysis supports the politicians who advocate a greater rate of growth of the
money supply when they feel that interest rates are too high. Of all the effects, only
the liquidity effect indicates that a higher rate of money growth will cause a decline
in interest rates. In contrast, the income, price-level, and expected-inflation effects
indicate that interest rates will rise when money growth is higher. Which of these
effects are largest, and how quickly do they take effect? The answers are critical in
determining whether interest rates will rise or fall when money supply growth is
Generally, the liquidity effect from the greater money growth takes effect immediately because the rising money supply leads to an immediate decline in the equilibrium interest rate. The income and price-level effects take time to work because
the increasing money supply takes time to raise the price level and income, which
in turn raise interest rates. The expected-inflation effect, which also raises interest
rates, can be slow or fast, depending on whether people adjust their expectations
of inflation slowly or quickly when the money growth rate is increased.
Three possibilities are outlined in Figure 5; each shows how interest rates
respond over time to an increased rate of money supply growth starting at time T.
Panel (a) shows a case in which the liquidity effect dominates the other effects so
that the interest rate falls from i1 at time T to a final level of i2. The liquidity effect
operates quickly to lower the interest rate, but as time goes by, the other effects start
to reverse some of the decline. Because the liquidity effect is larger than the others,
however, the interest rate never rises back to its initial level.
Panel (b) has a lesser liquidity effect than the other effects, with the expectedinflation effect operating slowly because expectations of inflation are slow to adjust W-38 Appendix 4 to Chapter 4 Interest Rate, i i1
Liquidity Income, Price-Level,
Inflation Effects ( a ) Liquidity effect larger than
Time Interest Rate, i i2
( b ) Liquidity effect smaller than
other effects and slow adjustment
of expected inflation T
Liquidity Income, Price-Level,
Inflation Effects Time Interest Rate, i i2
( c ) Liquidity effect smaller than
expected-inflation effect and fast
adjustment of expected inflation T
Income and PriceLiquidity and
ExpectedInflation Effects Figure 5 Time Response over Time to an Increase in Money Supply Growth upward. Initially, the liquidity effect drives down the interest rate. Then the income,
price-level, and expected-inflation effects begin to raise it...
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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.
- Spring '09
- Supply And Demand