CB2 September 2017 Q15

[Jamie]

Hi all,

I was wondering if someone would be able to explain the answer to this question "Which one of the following will occur, assuming spare capacity within the economy, if both government spending and the money supply are increased?".

The correct answer is - "national income will rise but the effect on interest rates is uncertain".

Is the explanation that as Y=C+I+G+(X-M) national income will rise as G has increased and as there is spare capacity in the economy although increasing the money supply should reduce interest rates firms are more likely to borrow to fulfill this spare capacity hence pushing interest rates back up?

Kind of clutching at straws to justify this answer so a better explanation would be appreciated!

Thanks,
Jamie

 

[Richie Holway]

Hi Jamie,

There are two things going on here, the increase in government spending and the increase in the money supply, and two models to consider, AD-AS and the money market.

Using the AD-AS model:

The increase in government spending will directly increase aggregate demand, shifting the aggregate demand curve to the right and so increasing national income. The increase in the money supply (and associated reduction in the interest rate) will increase AD further, again increasing national income. So overall, national income increases.

Using the money market model:

The increase in government spending and increase in national income will increase money demand, shifting the money demand curve to the right and so putting upward pressure on the interest rate. However, the increase in the money supply will shift the money supply curve to the right and so put downward pressure on the interest rate. The combination of upward and downward pressure on the interest rate means it is not possible to say the overall direction of movement.

Thanks,
Richie