We have a rule that says Ms / P = Md / P where Ms is the amount of money in the

Question

We have a rule that says Ms / P = Md / P
where Ms is the amount of money in the money supply and Md is the amount of money demanded for investment.

I have a question in my book which says as follows:

Ms = 30 and Md is defined by the formula = 30 – 5r
where “r” represents the interest rate.

So at the start r = 0. The question then went on to say that an inflationary gap occured in the economy, and therefore – based on the formula for the economy’s AD and NDP at equilibrium (which I won't mention here), r now has the value of 2. I understood it they said this.

The book then said that since

Ms = 30
and
Md = 30 – 5r
Md now has a value of 20 so P must have a value of 1.5, as in:

Ms / P = 30 / 1.5 = 20 = Md

But if P is 1.5 then the P that's under Md MUST ALSO BE 1.5, so we have
Ms / P = 30 / 1.5
which is supposed to equal
Md / P = 20 / 1.5

This is not correct, so I am not getting something here. The only way this can be true is if when the book says that Md = 30 – 5r it means Md / P = 30 - 5r

This would be very strange, since Md and P are 2 different variables.

Or perhaps I'm missing something. Please comment. Thank you

Explanation / Answer

Money supply in the market is determied by the IS-LM curve equillibrium

IS, where I represents the demand for investment and S is the level of saving.

LM: lL represents demand for money and M is the money supply in th market.

Ms/P = Md/P and the consitions here are price and Y are fixed.

When we consider that price levl is flexible, than during an inflationary gap,

we can have a contractual monetory polisy or a fiscal policy.

When there is a contactual monetory policy,

Here in the above example money supply decreases to 20, In monetory policy measure LM curve shifts left , and there will be an increase in the interest rate.

Ms=20

Md= 30-5i

20=30-5i

i=2%.

thus a 2/3% decrease in money supply will decrease the price level by 2/3P= 0.6P

altering the output Y to 20 ( 30 x 2/3P= 20)

You said it is 1.5P...its wrong..plz verify ur book, because a contractual policy will increase intrest rates and decrease price.

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