Question

1 Policy coordination:

What’s the effects of a combination of increasing money supply and reducing government spending on the real interest rate and the GDP in equilibrium.

Answer 1

Increase in money supply will shift the money supply curve rightward, decreasing interest rate and increasing the quantity of money. Lower interest rate will boost investment and consumption demand, raising aggregate demand which will shift the AD curve rightward and increase real GDP.

At the same time, lower government spending will reduce borrowing, lowering interest rate and will decrease aggregate demand, leading to a leftward shift of AD curve which will decrease real GDP.

So the net effect will be a definite fall in interest rate. Real GDP will rise (fall) if rightward shift in AD from higher money supply is higher (lower) in magnitude than the leftward shift in AD from lower government spending. If both shifts are equal in magnitude, real GDP will remain unchanged.