Question

a. Draw a carefully labeled money market diagram to show the initial equilibrium of the quantity of money and the price level.

b. Now suppose that changes in bank regulations expand the availability of credit cards, so the people need to hold less cash. Show (on the same diagram you drew above in part a) and explain how this will affect the demand for money.

c. If the Bank of Canada wants to keep price level stable, what should it do? Show this on the same diagram in a) and explain.

Answer 1

a) The diagram is shown below. Money supply curve is vertical and money demand curve is downward sloping. Vertical axis measures the value of money which is the reciprocal of price level. This implies that value of money = 1/price level. Initial equilibrium is at A

b) People are holding less cash so they demand less money. This shifts the money demand curve down. As a result the rate of interest is reduced. Value of money declines and price level rises. New equilibrium is at B

c) To keep price level stable, the supply of money should be decreased. This can take place by raising reserve requirements, discount rate or open market sale of treasuries. This will shift the money supply curve to the left, raising the rate of interest and raising the value of money so that price level is reduced and brought back to its initial equilibrium level. Final equilibrium is at C