Question

Under the liquidity preference (money market) framework, how will the following events affect real interest rates? Show your answer using graphs.

1. The economy enters a recession.

2. The Federal Reserve decreases the nominal money supply.

3. The price level decreases.

4. The price level and the nominal money supply both decrease by 17 percent.

Answer 1

In each graph, MD0 and MS0 are initial money demand and supply curves, intersecting at point A with initial interest rate r0 and quantity of money M0.

(1)

During recession, income falls, so people reduce consumption. Decrease in consumption will decrease the demand for money. The money demand curve shifts left, lowering interest rate.

In following graph, MD0 shifts left to MD1, intersecting MS0 at point B with lower interest rate r1.

(2)

When Fed decreases money supply, the money supply curve shifts left, increasing interest rate and decreasing quantity of money.

In following graph, MS0 shifts left to MS1, intersecting MD0 at point B with higher interest rate r1 and lower quantity of money M1.

(3)

Decrease in price level increases purchasing power (value of) money, which decreases the demand for money. The money demand curve shifts left, lowering interest rate.

In following graph, MD0 shifts left to MD1, intersecting MS0 at point B with lower interest rate r1.

(4)

Real money supply (MS) = Nominal money supply (M) / Price level (P)

% Change in MS = % Change in M - % Change in P = 17% - 17% = 0%

Therefore, an equal decrease in M and P keeps MS unchanged, so equilibrium stays unchanged at initial point A.