How Does An Increase In Money Supply Affect Real GDP?

Consumer spending, government spending, investment, and net exports all contribute to aggregate demand (AD).
A drop in the money supply is accompanied by a corresponding decrease in nominal output, also known as GDP ( GDP ).
Consumer spending will be affected by the reduction in the money supply. The AD curve will move to the left as a result of this decline.
An rise in the money supply is accompanied by an equal increase in nominal output, or GDP (GDP).
The expansion of the money supply will result in more consumer expenditure. The AD curve will move to the right as a result of this increase.
Increased money supply leads to lower interest rates and more spending, resulting in an increase in AD.

Does increasing the money supply boost actual GDP?

The GDP determined at current market prices is referred to as nominal GDP. Although nominal GDP usually rises in lockstep with the money supply, this is not always the case. Real GDP is an inflation-adjusted measure of a country’s GDP, often known as “constant-price,” “inflation-corrected,” or “constant-dollar GDP.” The relationship between real GDP and the money supply is less obvious. The productivity of economic agents and enterprises has a greater impact on real GDP.

When the money supply expands, what happens?

An rise in the money supply often lowers interest rates, which stimulates spending by generating more investment and putting more money in the hands of consumers. Businesses respond by expanding production and ordering more raw materials. The need for labor rises as company activity rises. If the money supply or its growth rate lowers, the opposite can happen.

What causes the increase in real GDP?

A rise in aggregate demand drives economic growth in the short run (AD). If the economy has spare capacity, an increase in AD will result in a higher level of real GDP.

Factors which affect AD

Lower interest rates – Lower interest rates lower borrowing costs, which encourages consumers to spend and businesses to invest. Lower interest rates cut mortgage payments, increasing consumers’ discretionary income.
Wages have been raised. Increased real wages enhance disposable income, which encourages consumers to spend.
Greater government expenditure (G), such as government investments in new roads or increased spending on welfare payments, both of which enhance disposable income.
Devaluation. A decrease in the value of the currency rate (for example, the Pound Sterling) lowers the cost of exports and increases the volume of exports (X). Imports become more expensive as a result of depreciation, lowering the quantity of imports and making domestic goods more appealing.
Confidence. Households with higher consumer confidence are more likely to spend, either by depleting their savings or taking out more personal credit. It encourages spending by allowing increased spending (C) (C).
Reduced taxation. Consumers’ disposable income will increase as a result of lower income taxes, which will lead to increased expenditure (C).
House prices are increasing. A rise in housing prices results in a positive wealth effect. Homeowners who see their property value rise will be more willing to spend (remortgaging house if necessary)
Financial stability is important. Firms will be more eager to invest if there is financial stability and banks are willing to lend, and investment will enhance aggregate demand.

Long-term economic growth

This necessitates an increase in both AD and long-run aggregate supply (productive capacity).

Capital increase. Investment in new manufacturing or infrastructure, such as roads and telephones, are examples.
Increased labor productivity as a result of improved education and training, as well as enhanced technology.
New raw materials are being discovered. Finding oil reserves, for example, will boost national output.
Microcomputers and the internet, for example, have both led to higher economic growth through improving capital and labor productivity. New technology, such as artificial intelligence (AI), which allows robots to take the place of human workers, may be the source of future economic growth.

Other factors affecting economic growth

Stability in the economy and politics. Stability is vital for convincing businesses that investing in capacity expansion is a sensible decision. When there is a surge in uncertainty, confidence tends to diminish, which can cause businesses to postpone investment.
Inflation is low. Low inflation creates a favorable environment for business investment. Volatility is exacerbated by high inflation.

Periods of economic growth in UK

The United Kingdom saw substantial economic expansion in the 1980s, owing to a number of factors.

Reduced income taxes increase disposable income, which leads to increased expenditure and, in turn, stimulates corporate investment.
House prices rose, resulting in a positive wealth effect, equity withdrawal, and increased consumer spending.

What effect does increasing the money supply have on the price level?

The worth of money is defined by the amount of money accessible in an economy, according to one of these assumptions. Because an increase in the money supply also causes the rate of inflation to rise, an increase in the money supply results in a fall in the value of money. Purchasing power declines as inflation rises. The purchasing power of a currency is defined as the amount of products or services that one unit of currency can purchase. When a unit of money’s buying power falls, it takes more units of currency to buy the same amount of products or services.

What effect does expanding the money supply have on inflation?

When would an increase in the money supply not result in a rise in inflation, according to a reader’s question?

Inflation is caused by increasing the money supply faster than real output grows. Because there is more money pursuing the same quantity of commodities, this is the case. As a result, as monetary demand rises, enterprises raise their prices.
Prices will remain constant if the money supply grows at the same rate as real output.

Simple example of money supply and inflation

The output of widgets increased by 20% in 2001. The money supply is increased by 20%. As a result, the average widget price remains at 0.50. (zero inflation)
In 2002, the output of widgets increased by 16.6%, and the money supply increased by 16.6%. Prices are unchanged, with a 0% inflation rate.
In 2003, however, the output of widgets increased by 14%, while the money supply increased by 42%. There is an increase in nominal demand as the money supply grows faster than output. Firms raise prices in reaction to the increase in demand, resulting in inflation.

Money supply can rise if

Banks like to keep their liquidity ratios low. As a result, banks will be more ready to lend a larger amount of their capital.
An influx of wealth from outside the country. If the Bank of England is required to purchase surplus pounds on the foreign exchange market in order to build up foreign reserves. This sterling will be used by foreigners to buy UK exporters, which will then be deposited in banks, resulting in the creation of credit, which will multiply the money supply. This will only happen if the B of E tries to keep the e.r below the equilibrium level.
Because bank deposits are considered liquid assets, if the government sells securities to the B of E, the money supply will rise.
If the er does not rise, the government will sell securities to foreign buyers, resulting in an increase in the MS.
The Bank of England offers Treasury notes to the banking industry. These are considered liquid assets and can be used as a liquidity base for additional customer loans. As a result, the money supply will grow at a doubled rate.
Bonds are sold by the government to the banking industry. Bonds are considered illiquid, and as a result, they will not be utilized as a basis for lending money.
The government sells bonds or bills to non-banking financial institutions. If the public purchases something from the government, their bank deposits will be reduced, and the money supply will not expand.
Fiscal policy that is expansionary. In a liquidity trap, lowering the liquidity ratio may not boost the money supply since banks and enterprises are unwilling to lend and borrow. There is sometimes a ‘paradox of thrift’ in the business world, with consumers wanting to increase their savings – which leads to a reduction in spending and investment. If the government borrows from the private sector and spends on public work investment programmes, a multiplier effect will occur, with families receiving wages to spend and private sector investment being encouraged.

Flow Of Funds Equation

If we want to compare the size of the money stock at one point in time (Mst) to that at a prior point in time (Mst-1), we must look at the money flow (change) between these two points (change Ms)
If the banking sector reduces its liquidity ratio in response to rising loan demand,
If there is a surplus in currency flows and so a net influx from overseas. The portion of government borrowing that is funded by borrowing in foreign currency is also included in item four, which lessens the government borrowing’s expansionary effect.

The relationship between Money Supply and the rate of interest

Some monetary theories presume that money supply is completely unaffected by interest rates. Keynesian models, on the other hand, assume that:

Higher credit demand will raise interest rates, making it more appealing for banks to extend credit.
Depositors may be enticed to move money from sight to time accounts if interest rates are higher. The liquidity ratio can then be reduced by the banks.

Why does increasing the money supply cause inflation?

Inflation can be divided into two types, according to Keynesian economists: demand-pull and cost-push. Desire-pull inflation occurs when customers demand things at a higher rate than production, maybe due to a bigger money supply. Cost-push inflation occurs when input prices for items rise faster than consumer tastes change, sometimes as a result of a higher money supply.

What effect does money availability have on economic activity?

They have influence over monetary policy tools such as the money supply. When a result, as a country’s money supply grows, so does its economic activity, and vice versa. Three factors will stifle a country’s economic growth.