Question

Explain how each of the following developments might affect the supply of money, the demand for money, and the nominal interest rate, if at all. Illustrate each answer with a diagram of the supply and demand for money.

a) The Fed’s bond traders buy bonds in an open market operation.

b) A bank panic hits the nation. People try to take all the money out of their checking accounts so they can hold it as cash.

c) Rising oil prices cause an increase in inflation.

Answer 1

a) If Fed's bond traders buy bonds in an open market operation then it leads to tu an increase in the money supply in the economy. In the face of an unchanged demand for money increase in the money supply leads to a decrease in the Nominal rate of interest. This is shown in the diagram below:

b) people try to take all the money out of their checking accounts so that they hold it as cash. This leads to to an increase in the demand for money and the money supply remains unchanged. increase in the demand for money leads to an increase in the nominal interest rates. This is shown in the diagram below:

c) rising oil prices cause an increase in inflation. Increase in inflation cause people to hold more cash so as to meet their expenditure of buying the same basket of goods and services as they were buying earlier. The money supply remains unchanged and increase in the demand for money by people leads to an increase in the nominal interest rate. This is shown in the diagram below.