In: Economics
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
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