3. Assume that the money market is initially in equilibrium and that the money supply is...

3. Assume that the money market is initially in equilibrium and that the money supply is then increased. Explain the adjustments toward a new equilibrium interest rate. Will bond prices be higher at the new equilibrium rate of interest? What effects would you expect that interest rate change to have on the levels of output, employment, and prices? Answer the same questions for a decrease in the money supply.

Expert Solution

(a) Increase in money supply

An increase in money supply will shift the money supply curve rightward, which will decrease interest rate and increase the quantity of money. Since bond price and interest rate are inversely related, lower interest rate will increase bond price. Since lower interest rate will increase investment demand, aggregate demand will rise, shifting AD curve rightward which will increase price level, increase real GDP & output and increase employment.

(b) Decrease in money supply

A decrease in money supply will shift the money supply curve leftward, which will increase interest rate and decrease the quantity of money. Since bond price and interest rate are inversely related, higher interest rate will decrease bond price. Since higher interest rate will decrease investment demand, aggregate demand will fall, shifting AD curve leftward which will decrease price level, decrease real GDP & output and decrease employment.

Rahul Sunny answered 2 years ago

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