Dear all,
In R13 subsection 6.2, one line is confusing me:
“With inflexible domestic prices in the short run, any increase in nominal money supply results in a decline in the domestic interest rate”
Why? This is not intuitive to me.
Think of it as an easy money policy. An increase in the money supply is making money more available to lend, with more money in the system banks/institutions will lend at lower rates rather than keep larger piles of cash on their balance sheets.
Think of money as a commodity (mainly because it is). Abundance decreases the price, scarcity increases the price. The price of money is interest.
To complement above statements (that are really accurate btw), the fact that “prices are inflexible in the short run” canalize the increase-in-money-supply pressure into lower interest rates and not into higher goods and services prices.
This is important, because if prices [of goods and services] were indeed really flexible in the short term, and economic agents knew it (including banks and other financial institutions), then the demand for money would increase proportionally to the increase in supply money. In simple words, higher money in the system would create just inflation and not making interest rates to fall.
However, this does not happen in real life. Prices are rigid in the short term but change in delay, I mean prices variation seen today are the result of policies made of a year ago.
Dornbusch overshooting model illustrates that: prices are is “sticky” in the short term. This is why price and hence interest rate which is price of money does not reflect immediate change in monetary policies.