Question

Financial markets and the LM relation. a) Explain why the money demand curve is downward sloping and what b) What types of policies can the central bank implement to reduce the interest c) Define the velocity of money. What effect does an increase in interest rate d) Illustrate graphically the effect of a drop in nominal income on the money e) Illustrate graphically the effect of a purchase of bonds by the Federal Reserve factor(s) cause shifts in the money demand curve. rate? have on the velocity of money? market. on the money market.

Answer 1

a)At a given interest rate, the quantity of money demanded is defined by the demand curve of money. The demand curve of money is downward sloping indicating that higher the interest people get from investments, the lower the amount of wealth they would hold in the form of money.The factors that can cause shift in the money demand curve are:

(i)Increase in real income due to increase in GDP at the given interest rate will cause a shift in the curve as the quantity of money demanded goes up.

(ii)A higher price level will also lead to greater demand for money to buy goods and services.

b)Government can use expansionary monetary policy to reduce interest rates. This will make it unfavorable for people to save the money hence increasing public spending. Also capital will be available at cheaper rates, thus favoring businesses and investments in projects.The most popular option is to change interest rates. The second popular way is to use fiscal policy; the government can reduce taxes and increase government spending.

c)Velocity of money is the frequency at which one unit of the money is spent to purchase goods and services per unit of time. In simple words, how fast money changes hands, passes from one holder to another is called velocity of money. Increase in interest rates is directly proportional to velocity of money. As the interest rates will rise, people find it less attractive to hold on to money and will try looking for advantageous options. The reduction in people holding money will cause the frequency of exchange that is the velocity of money to increase.

d) A decrease in nominal income will lead to a shift in the money demand curve, and the equilibrium will change from E1 to E.

e) The government buys bonds to maintain the short term interest rate, it does this by increasing the supply of money.

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