Question

Suppose that changes in bank regulations expand the availability of credit cards so that people need to hold less cash.

a. How does this event affect the demand for money?

b. If the Bank of Canada does not respond to this event, what will happen to the price level?

c. If the Bank of Canada wants to keep the price level stable, what should it do?

Answer 1

Answer :

a. How does this event affect the demand for money?

The money demand will fall because credit card is like an interest free loan for a particular period, so, people would prefer to hold less currency decreasing demand for money.

b. If the Bank of Canada does not respond to this event, what will happen to the price level?

If FED does not respond to increase in velocity of money, it will lead to decrease in interest rate in the economy due to excess supply of money inducing investment and consumption which will increase aggregate demand increasing price level and output. In long run, output will move back to full employment level but price level will increase further. So, there will be an increase in inflation.

c. If the Bank of Canada wants to keep the price level stable, what should it do?

FED need to reduce the money supply which will offset the effect of decrease in money demand’s effect on interest rate. Thus, keeping inflation rate stable. This can also be seen from equation of quantity of money,

Nominal Money supply*Velocity of money = Price level* Real output

So, increase in velocity will require decrease in nominal money supply otherwise at given level of real output, price will increase by same percentage as velocity of money.