Final answer:
A change in the quantity of money can affect output and employment by influencing total spending in the short run. It typically lowers interest rates, which may increase investment and thus output. Over the long term, excess money supply can lead to inflation if output cannot increase.
Step-by-step explanation:
To understand how a change in the quantity of money affects output, employment, interest rates, and prices, we must consider the various economic components and their interrelationships. A change in the money supply can have direct and indirect effects on these economic variables through different channels such as the interest rate, consumption, and investment decisions.
The traditional view, based on the quantity theory of money, suggests that an increase in the money supply (M) can lead to an increase in total spending in the economy since the velocity of money (V) is assumed to be stable in the short run. According to this model, higher spending should stimulate demand for goods and services, which can increase output (Y) and, correspondingly, employment (L). This relationship is explained by the assumption that prices may not adjust immediately due to price stickiness.
Increase in the money supply typically lowers the interest rate as there is more money available for loans. However, investment demand (I) in the model is inversely related to the interest rate (r), meaning that, theoretically, a lower interest rate would lead to higher investment spending, contributing to higher output.
Over the long term, if output cannot increase due to full employment or other constraints, the excess money in the economy will lead to higher prices, resulting in inflation. This is depicted in the equation of exchange MV=PY, where P represents the price level and Y the real output; if V and Y are constant and M increases, P must rise.