Question

Question 4 (6pts): Suppose the money market is in equilibrium, unexpectedly real GDP increases. What will happen to equilibrium in the money market? Describe either intuitively, feel free to use graphs to aid in your explanation. What should the Federal Reserve do to keep interest rates the same? How will it accomplish this? Specifically mention changes in the quantity of money and the interest rate.

Answer 1

The money market is in equilibrium at the point where the money demanded and money supplied intersect. At this point there is an interest rate r, at which the money supplied and demanded are just equal (hence equilibrium). This is shown below.

Interest Rate Money Supply Money demand Quantity of Money

As the real GDP increases, the income of everyone increases. This results in higher demand for money. This will shift the money demand curve to the right. Now the money supply is still the same in short run, so the new equilibrium point is higher now and hence the interest rate is higher, at r'. It is shown below.

Interest Rate Money Supply N Money demand Quantity of Money

If the federal reserve wants to keep the interest rate same, it must increase the money supply and hence shift the money supply curve to the right too. There are various ways through which the Fed can achieve this. One is to decrease the reserve ratio. Decreasing it will allow the banks to lend more money and hence increase the money supply. Fed can also buy back securities from the banks, thus again giving them more liquid money and hence increasing supply.

The increased supply of money will shift the money supply curve to the right, so that the new equilibrium point would again be lower. This would move the rate back to r. This is shown below.

Interest Rate Money Supply Money demand Quantity of Money

Please note that the red arrow shows the movement of money demand and the green shows the movement of money supply.