Monetary policy, Macroeconomics

Let us now see a bit more closely how monetary policy works. See Figure

Figure 

712_monetarypolicy.png

The initial equilibrium at point E is on the initial LM schedule that corresponds to a real money supply  247_Asset market and LM curve2.png  . Suppose now that the nominal quantity of money is increased, for example by open market operations. Given a constant price level, the real quantity of money increases as the nominal quantity of money increases. As a result of the increase in the real quantity of money, the LM schedule shifts to LM1.

For the new schedule LM1, the equilibrium will be at point E1 with a lower rate of interest and a higher level of income.

Let us see a bit more closely how with an expansion in real money supply the economy moves from the original equilibrium at E to the new equilibrium at E1. At the initial equilibrium point, E, the increase in money creates an excess supply of money. The public tries to adjust to the excess supply of money by buying financial assets. As a result of the increase in demand, the price of financial assets rises, and thus the yields decline. The adjustment process in the assets markets is much more rapid than that in the goods market and, therefore, we move immediately to point El when the money supply increases. At E1 the money market clears and the public is holding larger quantity of real money because the interest rate has declined sufficiently. At point E1, however, there is an excess demand for goods. The decline in the interest rate, given the initial income level Y0, raises aggregate demand and thus causes inventories to run down. In response, the output expands and we start moving up the LMl schedule. As output expands, the interest rate rises (after the immediate decline in interest rate when money supply is increased) because increase in output raises the demand for money and the increase in demand for money has to be checked by higher interest rates.

Posted Date: 9/18/2012 3:32:34 AM | Location : United States







Related Discussions:- Monetary policy, Assignment Help, Ask Question on Monetary policy, Get Answer, Expert's Help, Monetary policy Discussions

Write discussion on Monetary policy
Your posts are moderated
Related Questions
give and explain the different causes of national income variation

Identify a generic organization (e.g., manufacturing plant, hospital, educational institution). You will use this same organization in your Final Project. Assume that you are part

If interest rates increase, which would you rather be holding, long term or short term bond? Why? Which type of bond has the greater interest rate risk?

While referring to the "EYE on YOUR LIFE" section on page 389 of the textbook, discuss the change in the U.S. unemployment rate and inflation rate over the past year based on the P

What is the difference between heckscher_olin theory and comparative theory

What is Supply-side Economics Market Freedom? Markets must be allowed to work more freely and steps taken to improve this efficiency by:   freeing them from governm

iN BOTH CITIES, AN INCREASE IN INCOME COMBINED WITH EXPECTATIONS OF A STRONG MARKET SHIFTED DEMAND AND CAUSED PRICES TO RISE RAPLIDLY DURING THE MID-TO LATE 1980S. Illustrate with

Once we have monthly data on a price index we can evaluate the inflation. In most nations, the percentage change in price index during one month is small. Hence it is more common t

Review the Federal Reserve Board website. Identify at least five key pieces of data (links) you would use in microeconomic decision making on the Web site, and tell what data that

Suppose that several months of data showed the CPI increasing at a 4.5% annual rate due largely to increases in the price of energy and food related commodities following several y