Question

Suppose that changes in bank regulations expand the availability of credit cards, so

that people need to hold less cash. Use the money demand and supply diagram in the long run to answer

the following:

a.   How does this event affect the demand for money? (explain with graph + words)

b. If the Bank of Canada does not respond to this event, what will happen to the price level?

c. If the Bank of Canada wants to keep the price level stable, what should it do? (show on graph + explain with words)

Answer 1

(a)

Higher availability of credit card decreases demand for money. Money demand curve shifts lefward, which decreases interest rate.

In following graph, MD0 and MS0 are initial money demand and supply curves, intersecting at point A with initial interest rate r0 and quantity of money M0. When MD0 shifts left to MD1, it intersects MS0 at point B with lower interest rate r1.

(b)

Lower interest rate boosts investment demand, which increases aggregate demand. AD curve shifts rightward, increasing price level (and increasing real GDP).

In following graph, initial equilibrium is at point A where AD0 (aggregate demand) and SRAS0 (short-run aggregate supply) curves intersect with initial equilibrium price level P0 and initial equilibrium real GDP Y0. When aggregate demand increases, AD0 shifts rightward to AD1, intersecting SRAS0 at point B with higher price level P1 and higher real GDP Y1.

(c)

To keep price level stable, central bank has to decrease aggregate demand by lowering money supply. A fall in money supply shifts money supply curve to left, intersecting new MD curve at original interest rate.

In graph in part (a), MS0 shifts left to MS1, intersecting MD1 at point C with initial interest rate r0 and lower quantity of money M1.