The effect of money growth on output and the interest rate should be familiar (see IS/LM: Effects of monetary expansion). However, to analyze the effect of money growth on real interest rates and nominal interest rates, you must allow for expectations. Specifically, look at the relationship between real (r) interest rates and nominal (i) interest rates:

         i = r + pe

How does this affect the IS/LM graph we saw before? Interest rates enter the IS relationship only for investment decisions, and firms care about the real interest rate when making investment decisions (see first part of Chapter 14 for discussion on this topic). Interest rates enter the LM relationship only for money demand as the opportunity cost of holding money: the nominal interest rate. So we can alter the IS and LM equations slightly to account for expectations.

IS:
Y
=
C(Y-T) + I(Y, i- pe) + G
LM:
M/P
=
Y L(i)

The only difference from what you should be familiar with is the inclusion of expected inflation (which is assumed to be constant in the short run) in the IS curve.

  1. How does an increase in money growth affect the position of the IS curve ?
  2. How does an increase in money growth affect the position of the LM curve ?
  3. What is the effect of an increase in money growth on output in the short run ?
  4. What is the effect of an increase in money growth on the nominal interest rate in the short run ?
  5. What is the effect of an increase in money growth on the real interest rate in the short run ?