Thursday, December 18, 2014

Money Supply and GDP

A decrease in the money supply will have the effect of raising interest rates. Once the interest rates are increased, then business investment will decrease. The decrease in business investment, all things else being equal, will decrease the GDP, as the investment component will decrease. The multi-step process is illustrated graphically below.

Figure 2 adapted from Krugman & Wells p. 473

            Figure 2 represents the money market. The X-axis shows the quantity of money, or “real money”. The Y-axis shows the real interest rate, designated with a lower case “I”. The vertical lines represent the money supply, as determined by the Federal Reserve through open market operations. This graph shows the decrease in the money supply (M-bar one to M-bar two). The equilibrium interest rate at the meeting of the money supply and the line representing the demand for money is higher on the y-axis than it was previous. This represents an increase in the interest rate.
            The next step in related processes between a decrease in the money supply and the lowering of the GDP is looking at the relationship between the interest rate and overall investment. These are inversely correlated so that when the interest rate increases, as in the first graph, investment is lowered. The best way to illustrate the relationship is through side-by side graphs that directly trace the rise in interest rates with a concurrent drop in investment, but technologic limitations prevent that from being shown clearly here.          

Figure 3 adapted from Krugman & Wells p. 281
            In Figure 3, the y-axis is the same as in Figure 2, with the interest rate change from Figure 2 carried over from the previous graph. The x-axis represents the total investment expenditure, or” I”. The pink line shows the inverse relationship between the interest rate and the investment. As the money supply decreased, the interest rate increased. As the interest rate increased, the point on the pink line moved from E1 to E2. The total investment thus decreased in value as the interest rate increased in consequence of the decreasing money supply.
            Figure 4 will show the ultimate result of the decrease in the money supply: lowered GDP.

Figure 4 adapted from Krugman & Wells. p. 344

Figure 4 is the graph of GDP against aggregate expenditure. The graph is only at equilibrium where the `colored lines meet the 45-degree line in black. This graph shows that equilibrium GDP will be lower wen changed by a decrease in the investment component. All things being equal, the sum of consumer expenditures, government expenditures, business investment, and net exports will decrease if one of those components is lowered. The previous figures have shown graphically how decreasing the money supply increases interest rates, which decreased investment spending. Here is the culmination of those processes. GDP at equilibrium is lower (y2, representing the level of GDP at E2 where the green line intersects the 45-degree line).  Thus, decreasing the money supply decreases the GDP.

Krugman, P. & Wells, R. (2013). Macroeconomics. New York, NY : Worth Publishers