Question

Suppose the public (households and businesses) expect an increase in inflation within the next 18 months and the central bank is willing to accommodate changes in the public's behavior.

Discuss the impact on interest rate over time if the central bank accommodates the public desires' to hold more money balances by increasing the money supply on a continuing basis and the economy is near capacity. Be sure to discuss both the short run and the long run effects. You do not need a graph for this question just discuss the possible results.

Answer 1

If the public expects an increase in inflation rate within next 18 months, then in the short run demand for money will increase and thus money demand curve will shift rightwards. This will lead to increase in interest rate in the economy. Thus, in the short run interest rate of the economy will increase with the increase in inflation expectation of the public.

In the long run, if central bank accommodates the public desires to hold more money balances by increasing the money supply on a continuing basis, this will lead to rightwards shift of the money supply curve. Thus, interest rate will remain constant if the magnitude of increase in money supply is same as the magnitude of increase in money demand.