| a) You should always start out answering a question such
as this by asking the following question: what determines the real interest
rate? The answer, of course, is that it results from the equilibration
of savings and investment. So then, you should ask, is there anything on
the investment side that is affected by the money supply? The answer is
No: we assume in the classical model that investment depends only on the
real interest rate. Then ask the same question about saving. National saving
is given by S=Y-C(Y-t,r)-G,
and there is nothing in this equation that depends on the money supply
(you must be sure to understand why Y does not change when the money
supply changes). So, the real rate of interest is not affected by a
change in the money supply. |
| b) The labor market determines the real wage, w/p.
Now, a 10 percent increase in the money supply raises prices by 10 perent
(this is the central prediction of the quantity theory of money). But if
w/p has already been determined, and p goes up by
10 percent, then w must go up also by 10 percent. For this
answer to be complete, you should also establish that neither the labor
supply curve nor the labor demand curve shifts when prices go up by 10
percent. Doing so ensures that the equilibrium w/p is unaffected
by a change in the price level. |