When looking at the short run in Section 14.2, we showed how an increase in nominal money growth led to higher output, a lower nominal interest rate and a lower real interest rate.

The analysis in the text (as summarised in Figure 14.7)

assumed that expected inflation, Pe

, did not change in the short run. Let us now relax this assumption and assume that, in the short run, both money growth and expected inflation increase.

a. Show the effect on the IS curve. Explain in words.

b. Show the effect on the LM curve. Explain in words.

c. Show the effect on output and on the nominal interest rate. Could the nominal interest rate end up higher – not lower – than before the change in money growth? Why?

d. Even if what happens to the nominal interest rate is ambiguous, can you tell what happens to the real interest rate? (Hint: What happens to output relative to Figure 14.7? What does this imply about what happens to the real interest rate?)

EXPLORE FURTHER