The diagram below shows the demand for money and the supply of money: A) Explain
ID: 1220026 • Letter: T
Question
The diagram below shows the demand for money and the supply of money:
A) Explain why the Money Demand Curve is a downward sloping curve.
B) Suppose the interest rate is at iA. Explain how firms and households attempt to satisfy their excess demand for money. What is the effect of their actions?
C) Suppose the interest rate is at iB. Explain how firms and households attempt to dispose of their excess supply of money. What is the effect of their actions?
D) Now suppose there is an increase in the transactions demand for money because of growth in real GDP. Beginning at i*, explain what happens in the money market. How is this shown in the diagram?
2 B MD (Y, P) 0 Quantity of MoneyExplanation / Answer
1) Money demand curve is downward sloping because there is an inverse relation between rate of interest and demand for money. At higher rate of interest, it is costly to borrow money which reduces the demand for money and vice versa.
2) At iA, demand for money is higher than supply of money. Here, the government will intervene and increase the supply of money by buying bonds. This will shift the money supply curve and market will be in equilibrium.
3) At iA, demand for money is lower than money supply. Therefore, to maintain equilibrium in the market, the government will reduce the money supply by selling bonds in the market.