Question

Using the money demand and money supply curves, explain how the money market explains the relationship between interest rates and price levels as discussed in the interest rate effect (shape of AD).

Answer 1

It is believed that when there is high interest rates, then price level decreases as economy slows down and vice-versa. There exists a negative relationship between the two price and interest rate.

This relationship is explained by the money market:

As shown in the graph, the money demand curve is the downward sloping straight line showing negative relation between interest rate and quantity of money.

Money supply curve is the vertical line.

Let Central bank adopts expansionary monetary policy which increases the flow of money into the economy. This would shift the Money Supply curve Ms from Ms to Ms1. As a result, there is a downward movement along the money demand curve. At new equilibrium, the interest rate reduces from r to r1. Due to lower interest rates, people will start taking loans from the banks as borrowing becomes less expensive.

People, then spend higher income on goods. The demand for goods will increase. This increased demand will raise the prices of goods and shows inflation.

Hence, lower interest rates leads to higher price level.