Question

In the LM curve diagram, for a given total income/output in the economy, the demand for real money balances is higher than real money supply when the interest rate is:

A. equal to the equilibrium interest rate.

B. above the equilibrium interest rate.

C. below the equilibrium interest rate.

D. none of the above.

Answer 1

The real money supply function is a vertical line in the graph with the real interest rate on the vertical axis and real money balances on the horizontal axis.

When the demand for real money balances is higher than real money supply when the interest rate is  above the equilibrium interest rate.
So in such case  there is an excess supply of money in the money market. Practically, what this means is that individuals are holding more money than they would like given the high real interest rate. Accordingly, individuals will attempt to rebalance their portfolios; i.e. they will try to get rid of money by buying bonds (our generic non-money asset). In doing so the demand for bonds increases and so the price of bonds increases. Because bond prices are inversely related to the interest rate on bonds, the increased price of bonds lowers the real return on bonds (holding expected inflation fixed). Therefore, the excess supply of money at higher interest rate  leads to economic forces that act to lower the real interest rate. These forces cease to operate when the real interest falls twhere the demand for real balances is equal to the supply of real balances.