ECON1101 | Impact of Rise in Interest Rate on Money Supply

1.(A) If the Federal Reserve Bank decrease the interest rate at their next meeting, then it would enhance the money supply in the domestic market. With fall in the interest rate, incentive to save will be less as the return under the lower interest rate will also fall (Keynes 2018). Thus, investors will prefer to hold money in liquid form rather than saving the same in the financial institution.

Figure 1: Impact of rise in interest rate on money supply

Source: (Weale et al. 2015)

As it can be seen that from the figure 1, if the interest rate falls from old equilibrium price to new equilibrium price, then it will enhance the money supply. From old equilibrium quantity to new equilibrium quantity.

(B)With fall in the interest rate, there will be fall in the investment (I) in domestic market as the savings would be less. However, with rise in the money supply, there will be rise in the Consumption (C) that will enhance Aggregate Demand in the market (Goodfriend 2016).

Figure 2: Impact on AD-AS of fall in interest rate

Source: (Ihriq et al. 2015)

Fall in the interest rate will lead to fall in the price level and as per figure 2, it can be seen that fall in the price will enhance the aggregate demand in the market leading to rise in the GDP from Y1 to Y2. This fall in the price level will lead to fall in the employment in future within the domestic economy as with fall in the price, producers will face less motivation to produce more amount of output.

2.(A) In order to deal with the inflation rate classical economists argue that altering the interest rate will be beneficial. With rise in the interest rate, there will be fall in the liquidity in the market and it will reduce the demand of the goods and services in the market.  Further, it will enhance the incentive to produce more goods and services to the producer allowing the output of the economy to rise and price level as well the inflation rate to fall (Ihriq et al. 2015). As it can be seen from the figure below, with rise in the interest rate, there will be fall in the money supply and the aggregate demand will fall as well leading to fall in the general price level and inflation too.  

Figure 3: Impact of interest rate on money supply

Source: (Erceg and Linde 2014)

(B) Under the Keynesian model, it can be seen that they focus on the demand side policies to deal with the inflation rate. As the policy, Keynesian economists argue rise in the employment rate will allow the market demand to rise and production to rise as well (Best and Kleven 2017). This will bring in market equilibrium and will reduce the inflation as well.

Figure 4: Keynesian policy to reduce inflation

Source: (Ihriq et al. 2015)

(C)Under the supply side model, in order deal with the inflation, focus is given to the supply curve and shifting of the same rightward allows the economy to reduce the inflation. With shift in the supply curve, there will be fall in the price level and inflation in the market will eventually be reduced (Weale et al. 2015). As it can be seen from the figure below if the demand is constant, then with the effective supply side policies like deduction in tax, will enhance the output level in the domestic economy and it will lead to fall in the general price level in the market leading to fall in the inflation rate as well.

Figure 5: Supply side policies

Source: (Erceg and Linde 2014)

3.(A)A cut in the income taxes by the $400 billion along with the MPC value equals to 0.8 will impact the output of the economy positively. With fall in the income tax, there will be rise in the aggregate demand as with fall in the tax, there will be rise in the liquidity in the market. On other hand, inflation in the market will fall as there will be fall in the general price level and eventually with rise in the aggregate demand, there will be rise in the price leading to rise in the inflation rate (Fallick and Elliott 2016). As it can be seen from the above figure 1 & 2, with fall in the income tax, liquidity in the market will rise, it will lead to rise in the aggregate demand leading to rise in the overall performance level of the economy.

(B):Reduction in the tax deduction will cause in fall in the budget deficit and the national debt also gets enhanced. With fall in the tax, there will be higher aggregate demand as compared to before and it will lead to enhancement in the governmental income. Thus, budget deficit and national debt will also fall eventually leading to fall in the tax (Hagy 2015).

References:

Best, M.C. and Kleven, H.J., 2017. Housing market responses to transaction taxes: Evidence from notches and stimulus in the UK. The Review of Economic Studies, 85(1), pp.157-193.

Erceg, C. and Lindé, J., 2014. Is there a fiscal free lunch in a liquidity trap?. Journal of the European Economic Association, 12(1), pp.73-107.

Fallick, L. and Elliott, R.F., 2016. Incomes Policies, Inflation and Relative Pay. Routledge.

Goodfriend, M., 2016, August. The case for unencumbering interest rate policy at the zero bound. In Federal Reserve Bank of Kansas City’s 40th Ec

Hagy, A., 2015. Inflation Volatility and Economic Growth: A Disaggregated Analysis (Doctoral dissertation, Duke University Dur

Ihrig, J.E., Meade, E.E. and Weinbach, G.C., 2015. Rewriting Monetary Policy 101: What's the Fed's Preferred Post-Crisis Approach to Raising Interest Rates?. Journal of Economic Perspectives, 29(4), pp.177-98.

Keynes, J.M., 2018. The general theory of employment, interest, and money. Springer.

Weale, M., Blake, A., Christodoulakis, N., Meade, J.E. and Vines, D., 2015. Macroeconomic policy: inflation, wealth and the exchange rate. Routledge.