Question

MS Monetary Policy - End of Chapter Problems 8. Suppose that the money market in Westlandia is initially in equilibrium, and the central bank decides to decrease the money supply. In the short run, this decrease in the money supply will the interest rate. Interest rate, r MD In the accompanying diagram, shift the MD and/or MS curves and move the equilibrium point to its new position to illustrate the short-run and long-run effects of the decrease in the money supply (you do not need to label the short-run equilibrium, only the long-run equilibrium). Comparing the long-run equilirium to the initial equilibrium, the equilibrium interest rate Quantity of money

Answer 1

Rate of Interest on ---- MD 4 centity of Money lon in the

Initial equilibrium occurs when money demand equals money supply which is occurring at point E.

As money supply reduces which shifts the MS curve to its left from MS to MS1 raising the rate from interest from i to i1 while quantity of money falls from point Qm to Qm1. It shifts the point from point E to E1.

In long run, people will reduce their investment level due to rise in interest rate which will reduce the money demand from MD to MD1 which will reduce the rate of interest to its initial level of i while quantity of money remains the same at point Qm1. It shifts the equilibrium from point E1 to E2.