Question

Explain how a decrease in the money supply affects the money market and the position of the aggregate-demand curve. What is the effect for a closed economy and for a small open economy?

Answer 1

A decrease in money supply, brings leftward shift in the money supply in the money market. As a result, the interest rate increases in the economy. The increase in interest rate, causes the discouragement to the consumption spending. It will reduce the aggregate demand and the AD curve will shift to the leftward direction.

In a closed economy, when aggregate demand will come down, then supply will also be reduced in response to the lower demand. It will create loss of jobs and economic conditions will be worsened. Though, the impact will be less felt in the open economy as excess supply due to the decreased level of demand, will be sold in the international market. So, net export will increase for the small open economy. Besides, the rise in interest rates, will attract investments or supply of funds from the overseas investors when there is open economy. It will improve the exchange rate and domestic currency will appreciate.