Question

Describe the effect of a $40 billion increase in the money supply under these conditions:

a. a $40 billion increase in the money supply reduces the interest rate by 1%,

b. a 1% decrease in the interest rate increases investment spending by $60 billion,

c. the spending multiplier is 2.5

You can use some diagrams to explain your answer if necessary.

Answer 1

With an increase in the money supply by $40 billion the interest rate will fall as with an increase in money supply the interest rate tends to fall. The interest rate and investment have inverse relation, so with a fall in interest rate, the investment increases. The investment here increases with $60 billion. The spending multiplier here is given as 2.5. So the change in Income with a change in investment will be equal to $150 billion that is 2.5x60. So with an increase in the money supply of $40 billion the Income increases by $150 billion.