Question

Use the money market model to conduct the following analysis. For each of the following events, (i) say which curve shifts, (ii) say in which direction it shifts, and (iii) say in which direction the equilibrium interest rate changes.

a. Stock prices fall significantly.

b. The U.S. price level rises.

c. The Fed engages in an open market sale of bonds.

d. Credit card fraud becomes a major problem and people start making more payments using money.

Answer 1

Keynes developed a money market to determine interest rate, Interest rate is what makes money demand and supply equal. He considers his liqudity preference theory as the basis of this model. real money supply is not dependent on interest rate.So it is vertical as shown below.

a) what happens when stock prices fall significantly, investors in stock market will be more pesisimist and as uncerntainity prevails they stop investing more money in stocks and they will rather hold this money and even who owns these stocks try to sell of stocks. So that money demand will be increased, it will shift to right. This will make interest rate to increase further to meet the existing supply of money.

b) If price level increases this cause a fall in real money supply balances this will shift the real money supply curve to shift left. This in turn will increase the interest rate to match less real money supply to meet the exisiting money demand.

c) If a fed engages in an open market sale of bonds, this In turn if it means Fed is selling bonds. If fed decides to sell bonds this will make people and banks to buy these bonds. Once brought, this will reduce the liqudity availaible in the market. So money supply will be reduced in the economy. This will shift money supply curve to the left and increase the interest rate.

d) Since there are too many fruads, banks might have come with newer restrictions which will reduce the amount of credit cards in the economy. We have to remember credit cards are used to only defere payments so they infact will not effect money supply but only money demand. Since, the availaiblity of cards are reduced due to increase in restrictions cause of frauds. People make payments using money more, this will in turn will increase the demand for the money, With money supply being constant, an increase in demand for money will always rise the interest rate as shown below.