Interest Rate Determination

In this story, we relax the assumption of extreme full employment and assume instead that there is a very high rate of unemployment in the economy. This example will show how money supply increases can affect national output as well as prices.

Suppose there is a money supply increase as in the previous story. When Ford Motor Company goes out looking for a construction company to hire, there is now an important new possibility. Since unemployment is very high, it is likely that most construction companies are not operating at their full capacity. Some companies may have laid off workers in the recent past due to a lack of demand. The construction company that wins the Ford contract will not have to give up other construction projects. Instead, it can simply expand output by hiring unemployed workers and capital. Because there is a ready and waiting source of inputs, even at the original wage and rental rates, there is no need for the construction company to charge Ford more than current prices for its services. Thus there is no pressure to increase wages or the prices of construction services.

It is true, there is more money being paid out in wages by this company, and the new workers will go out and spend that money, leading to an increase in demand for restaurant services, cameras, dance lessons, and other products. These companies are also likely to respond by hiring more workers and idle equipment to provide more restaurant meals, cameras, and dance lessons. Here too, with a ready and willing source of new inputs from the ranks of the unemployed, these companies will not have an incentive to raise wages, rents, or prices. Instead, they will provide more output of goods and services.

Thus as the increase in money ripples through the economy, it will stimulate demand for a wide variety of products. However, because of high unemployment, the money supply increase need not result in higher prices. Instead, national output increases and the unemployment rate falls.

A comparison of stories 1 and 2 highlights the importance of the unemployment rate in determining the extent to which a money supply increase will be inflationary. In general, we can conclude that an increase in the money supply will raise the domestic price level to a larger degree in the long run, thus lowering the unemployment rate of labor and capital.