Question

please respond to the following in a minimum of 175 words:

Explain what happens to the interest rate if the money supply increases or decreases and the money demand remains unchanged. Explain what happens to the interest rate if the money demand increases or decreases and the money supply remains unchanged.

Answer 1

We know that nominal interest rate is the cost of holding money . When we hold money we forgo the interest rate that the money could have earned if kept in bank . So interest rate is like price of money ( considering money as a good here ) . In an economy money supply is decided by the central bank and hence it is almost fixed , so it is a vertical line . If money supply increases the curve shifts right , which causes the equilibrium interest rate to fall . If money supply decreases , the banks have lesser money to loan out so the equilibrium interest rate rises .

Now when money demand increases ( the demand curve is a downward sloping line ) , the demand curve shifts rightwards causing the interest rate to rise . When money demand decreases , the interest rate decreases . This is the transaction demand for money . The shift in the demand curve for money is caused by factors other than interest rate , such as real GDP or price level .