Question

Explain what happens to real money supply and real money demand in each of the following scenarios in the short-run. Illustrate your answer using a diagram with real interest rate on the vertical axis and real money on the horizontal axis. Label the axes and curves clearly.

a) Nominal money supply increases

b) Many more stores accept digital payment technologies like credit cards

c) Stock market crashes

d) Price Level rises and nominal money supply is fixed

Answer 1

In following graphs, MD0 and MS0 are initial money demand and supply curves, intersecting at point A with initial interest rate r0 and quantity of money M0.

(a)

Increase in money supply will shift money supply curve rightward, decreasing interest rate and increasing quantity of money.

In following graph, as MS0 shifts right to MS1, it intersects MD0 at point B with lower interest rate r1 and higher quantity of money M1.

(b)

Higher acceptance of digital payment will decrease demand for money, which will shift money demand curve leftward, decreasing interest rate.

In following graph, as MD0 shifts left to MD1, it intersects MS0 at point B with lower interest rate r1 and same quantity of money M0.

(c)

A stock market crash lowers household wealth and income, which will decrease demand for money, and will shift money demand curve leftward, decreasing interest rate.

In following graph, as MD0 shifts left to MD1, it intersects MS0 at point B with lower interest rate r1 and same quantity of money M0.

(d)

Higher price level erodes purchasing power of money, which will increase demand for money, and will shift money demand curve rightward, increasing interest rate.

In following graph, as MD0 shifts right to MD1, it intersects MS0 at point B with higher interest rate r1 and same quantity of money M0.