In the text we discussed the historical debate between Keynesians and Monetarists regarding the effectiveness of monetary policy in changing real GDP (see Figure 27 -10 to review). Using the same sort of diagram, discuss two conditions in which a change in the money supply would have no short-run effect on real GDP.

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FIGURE 27-10 Two Views on the Strength of Monetary Changes Interest Rate M M Interest Rate 0 0 M. M Quantity of Money (i) Changes in the money supply are effective M M Interest Rate Interest Rate Investment 0 M. M Quantity of Money Mp 0 14 Investment (ii) Changes in the money supply are ineffective The effect of a change in the money supply on aggregate demand depends on the slopes of the Mp and IP curves. Initially, in parts (i) and (ii), the money supply is Mg, and the economy has an interest rate of io and investment expenditure of lo. The central bank then expands the money supply from M to Ms. The rate of interest thus falls from to to it, as shown in each of the left panels. This causes an increase in investment expenditure of Al, from lo to I, as shown in each of the right panels. In part (i), the demand for money is insensitive to the interest rate, so the increase in the money supply leads to a large fall in the interest rate. Further, desired investment expenditure is highly interest sensitive, so the large fall in interest rates also leads to a large increase in investment expenditure. In this case, the change in the money supply will be very effective in stimulating aggregate demand. In part (ii), the demand for money is more sensitive to the interest rate, so the increase in the money supply leads to only a small fall in the interest rate. Further, desired investment expenditure is much less sensitive to the interest rate, and so the small fall in interest rates leads to only a small increase in investment expenditure. In this case, the change in the money supply will be less effective in stimulating aggregate demand.