| Consider the following statements regarding the money supply and the interest rate. |
| 1. Using monetary tools, the Central Bank can lower interest rates by raising the money supply and increase rates by cutting the money supply. |
| 2. This analysis can only consider the short run and not the long-term consequences of changes to the money supply. |
| 3. According to Keynes, the increase in the money supply may actually cause interest rates to go up. |
| Which of the statements given above are correct? |
A) 1 and 2
B) 2 and 3
C) 1 and 3
D) All of these
Correct Answer: A
Solution :
[a] Milton Friedman argued that while Keynes' analysis was technically correct, he failed to consider the longer term effects of monetary policy. Friedman argued that increasing the money supply may actually cause interest to go up. An increase in the money supply will cause income to rise, spurring an increase in money demand and interese rates. An increase in the money supply will stimulate spending, which will then cause prices to rise. Higher prices will increase money demand and raise interest rates. If the increase in money supply is continuous, then people will expect higher inflation. This causes the nominal interest rate to rise.
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