Question

Q2:

Starting at the equilibrium point called “A” of Demand for money curve (DM) and Supply of money (MS1). Now suppose Bank of Canada increases money supply to MS2, and the value of money and price level adjust to bring supply and demand for money into a new equilibrium point called “B”. EXPLAIN CAREFULLY THE ADJUSTMENT PROCESS OR WHY THE ECONOMY MOVES FROM point “A” to point “B”?     

Answer 1

Demand for money is a downward sloping curve. It depends on income and interest rate. Higher the interest rate, lower will be the demand for money for transaction purpose and vice versa. Supply of money is independent to interest rate and hence, it is vertical. It is the decision of central bank to decide the amount of money to be supplied in the economy. The point where demand and supply curve of money intersects is the equilibrium point. The corresponding interest rate is the equilibrium interest rate and quantity of money is the equilibrium quantity of money. Let the equilibrium be named as A. When the central bank decides to increase the supply of money, it purchases more bonds. Increase in demand for bonds raises the price of bonds. With the purchase of bonds, money supply increases, the supply curve shifts outward, that is, there is a parallel shift in MS curve. When more money is injected in the economy, the interest rate falls. This fall in interest rate increases the amount of investment. Investment increases. This inturn increases the income. Thus, new equilibrium is determined by the intersection of demand curve and new supply curve MS2. Equilibrium income increases and equilibrium interest rate falls.