Question

What will happen to the nominal interest rate and the equilibrium quantity of money because of the following changes? Draw a separate diagram (of the static liquidity-preference model) for each case and explain. Label the diagram clearly. a) A decrease in money supply. b) An increase in the level of prices

Answer 1

Suppose the money market is equilibrium when money demand curve MD and money supply curve MS interescts and thus determines the equilibrium quantity of money Qand nominal rate of interest r .
Demand for money curve is negatively sloped curve showed negative relationship between demand for money and interest rates. Money supply curve is vertical straight line. Because money supply is exogeneously determined by central bank.
1. If central bank decrease money supply in the economy. It will shift the money supply backward to MS1. MS1 curve intersects money demand curve at point B and determines the Q1 level of equilibrium quantity of money and r1 level of nominal interest rate. Reduction in money supply reduces equilibrium quantity of money and rises the interest rate.
2. An increase in price level causes increase in money supply. It will shift the money supply curve into right ward as MS1 from previous equilibrium at point B. The new MS1 curve and MD curve determines the equilibrium quantity of money Q1 and nominal rate of interest r1. Higher price level increases money supply and equilibrium quantity of money but reduces nominal rate of interest