Question

3. Assume that country J is in a situation of short and medium run equilibrium. Assume that the government of J wants to foster output without increasing public expenditures. i. Which policy should the govern ment adopt? [2p] ii. Explain the short-run effects of this policy on interest rate, investments and money supply. [4p] iii. Explain the medium-run effects of the policy on the price level and on the real money supply.[3p] iv. What happens to the nominal exchange rate of the national currency? [2p] a. C

Answer 1

a.i) If the government wants to foster growth without increasing government expenditure, it must adopt expansionary monetary policy. Expansionary monetary policy injects money supply into the economy which gradually leads to increase in aggregate demand and output level.

ii) The short-run effects of this policy are as follows:

Expansionary monetary policy increases the supply of loanable funds in the funds market. As a result, the supply curve for loanable funds shifts to the right. This results in lowering interest rates.

As interest rates decreases, demand for borrowing money for growth and development in the economy increases. Fall in interest rates has positive impact on both consumer spending and investment. With increase in consumption and investment, aggregate demand increases.

The policy increases money supply in the economy. This role is played by the central bank of the country.

iii) The medium-run effects of this policy are as follows:

In the medium-run, there is no effect on interest rate and output level. Hence, real money supply remains unchanged.

However, due to this policy, price level increases in the medium-run. With rightward shift in aggregate demand to the right in the medium-run, aggregate supply curve also shifts upwards to its left. As a result, price level increases in the medium-run.

iv) In general, with decrease in interest rates and increase in aggregate demand, the currency depreciates and the exchange rate falls under flexible exchange rate. Under fixed exchange rate , no effects are seen on the exchange rate.