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natural level, as does the unemployment rateand the price level is higherA decrease in velocity causes the AD curve to shiftto the leftReal GDP falls; Price level fallsUnemployment level rises as GDP fallsThe economy is in a recessionary gapIn the short run a decrease in velocity lowersReal GDP and increases unemployment rateIn the long run, Real GDP returns to its naturallevel, as does the unemployment rateThe Monetarist View of the Economy:Economy is self-regulatingChanges in velocity and the money supply can change aggregate demandChanges in velocity and the money supply will change the price level and Real GDP in the short run but only the price level in the long run14 – 4: Money and Interest RatesWhat Economic Variables Does a Change in the Money Supply Affect?Supply of loans, Real GDP and Price LevelMoney and the Supply of Loans:oWhen the Fed conducts an open market purchase, the supply of loans risesoWhen the Fed conducts an open market sale, the supply of loans fallsMoney and Real GDP:oIn the short run an increase in the money supply will increase price level and Real GDPoA decrease in the money supply produces a lower level of Real GDP and lower price levelChanges in the money supply can affect…The supply of loans17
Real GDPPrice LevelThe expected inflation rateThe Money Supply, the Loanable Funds Market and Interest Rates:The demand for loanable funds is downward slopingoBorrowers will borrow more funds as the interest ratedropsThe supply for loanable funds is upward slopingoLenders will lend more funds as the interest raterisesIf there is a surplus of loanable funds, the interest rate fallsIf there is a shortage of loanable funds, the interest rate risesThe supply of loans, Real GDP, the price level and the expectedinflation rate affect either the supply or demand side and in turn affect the interest rateSupply of Loans:A Fed open market purchaseincreases reserves in the bankingsystem and therefore increasesthe supply of loanable fundsInterest rate declinesLiquidity Effect: the change inthe interest rate due to a changein the supply of loanable fundsReal GDP:As real GDP rises, individualsbecome wealthier, and they tend to buy more bonds (extend more loans)The supply of loanable funds increasesWhen Real GDP rises, corporations issue orsupply more bonds, thereby demandingmore loanable fundsAs Real GDP increases, both supply anddemand for loanable funds increasesThe interest rate risesIncome Effect: the change in interest rate due to achange in Real GDPThe Price-Level Effect: The change in the interest rate dueto a change in the price level 18
With respect to the interest rate effect, when the price level rises, the purchasing power of money fallsPeople may therefore increase their demand for credit or loanable funds to borrow the funds necessary to buy a fixed bundle of goodsExpectations Effect: the change in interest rate due to a change in expected inflation rate