Interest Rate Determination

Story 3: Money Supply Increase above and below the Natural Unemployment Rate

Suppose there is a money supply increase as in the previous story, but now let's assume the economy is operating above full employment, meaning that unemployment is below its natural rate.

As the money supply increase ripples through the economy causing excess demand, as described above, businesses have some leeway to expand output. Since unemployment is not zero, they can look to hire unemployed workers and expand output. However, as frictional unemployment decreases, the labor market will pick up speed. Graduating students looking for their first job will find one quickly. Workers moving to another job will also find one quickly. In an effort to get the best workers, firms may begin to raise their wage offers. Workers in transition may quickly find themselves entertaining several job offers, rather than just one. These workers will begin to demand higher wages. Ultimately, higher wages and rents will result in higher output prices, which in turn will inspire demands for higher wages. Thus despite the existence of some unemployment, the money supply increase may increase output slightly but it is also likely to be inflationary.

In contrast, suppose the economy were operating with unemployment above the natural rate. In this case, the increase in demand caused by a money supply increase is likely to have a more significant effect upon output. As firms try to expand output, they will face a much larger pool of potential employees. Competition by several workers for one new job will put power back in the hands of the company, allowing it to hire the best quality worker without having to raise its wage offer to do so. Thus, in general, output will increase more and prices will increase less, if at all. Thus the money supply increase is less likely to be inflationary in the long run when the economy is operating above the natural rate of unemployment.