Question

In macroeconomics, the effect of monetary policy is an issue that has caused many debates and controversies. Consider an economy that is initially in a short-run equilibrium. If the central bank decides to increase money supply, what exactly is the impact of this policy on the economy in the short run and in the long run? In this question, you will argue that the answer to this question depends on initial conditions. That is, it depends on the nature and/or position of the initial short-run equilibrium.

Write a short essay to explain the short- and long-run impact of this monetary policy, and how your answer depends on the initial conditions. Feel free to use any models you learned in this class to illustrate your answer. Your answer should be typed. The graphs can be drawn on paper.

Answer 1

In short run assuming equilibrium at E1, when expansionary monetary policy is applied the liquidity levels rise through either rate cuts, or bond buying programmes or other tools.

This causes the credit availability and loanable supply of funds to rise and thus market is flooded with higher cash which leads to exponentially high growth in consumption and aggregate demand and thus in short run equilibrium moves upwards to E2 and thus real GDP and prices rise.

However in longvrun, self adjustment takes place and economt comes back to E1.

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