Answer the following questions on the demand for money and the money market. (a)

Question

Answer the following questions on the demand for money and the money market.

(a) Explain and show what happens in the short-run money market when there is an increase in real income. (Assume all prices except the real interest rate are fixed, and there is no inflation or expected inflation.)

(b) Explain and show what happens in the long-run money market when there is an increase in inflationary expectations.

(c) Explain and show what happens in the long-run money market when the central bank increases the (nominal) money supply.

(d) Why is the demand for money inversely related to the nominal interest rate?

Explanation / Answer

(a) Given there is no inflation, the nominal and real interest rates will be the same as per the Fishers equation. Now if the real income increases then this will mean that the demand for money will increase as people want to spend more. This will cause the demand for money curve to shift upwards and there will be an increase in real interest rates as a result. This is assuming that money supply is fixed. So as real income rises money demand rises and so interest rates rise.

(b) An increase in inflationery expectations will mean that the nominal interest rates will increase as per the Fishers equation. This will cause a fall in the demand for money and hence the LM curve will shift upwards. This will cause output to fall as people spend less as interest rates rise. Thus as the LM curve shifts upwards output falls in the long run.

(c) As the money supply increases the vertical money supply curve will shift rightwards and cause a fall in the interest rates. This will cause the the LM curve to shift rightwards and so interest rate falls and the output level rises as people spend and invest more as the interest rate falls.Over time the interest rate adjusts itself back to equilibrium levels.

(d) As interest rates increase, it becomes more expensive to borrow and so the demand for money curve will shift downwards. The fact that an increase in interest rates causes a fall in the demand for money as people find it tougher to invest will mean there is a negative relationship between the demand for money and the nominal interest rate.

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