Interest Rate Determination

Learning Objective

1. Understand the conditions under which changes in the money supply will have a long-run impact on the price level and hence the inflation rate in a country.

In previous sections we assumed that price levels were given exogenously and were unaffected by changes in other variables. In this section, we will argue that money supply increases tend to have a positive effect on the price level and thus the rate of inflation in an economy. This effect is unlikely to occur quickly, instead arising over several months or years. For this reason, we will say the effect occurs in the long run. The magnitude of the price level effect is also greatly influenced by the level of unemployment in the economy. Unemployment affects the degree to which the money increase affects prices and the degree to which it affects output.

The easiest way to see the linkage between money supply and prices is to simplify the story by assuming output cannot change. We tell that in story 1. This assumption allows us to isolate the impact of money on prices alone. In the subsequent adjustment stories, we'll relax the fixed output assumption to show how money increases can also affect the level of output in an economy.