Question

1. Consider the money demand and money market diagram. Starting with an initial equilibrium, show graphically how each of the following changes effects the price level

a. The Federal Reserve lowers the reserve requirement.

b. Consumers believe that their dollars will not be able to buy as many goods as before

c. A new app allows you to use your smart phone to pay for all the goods and services you want to buy.

Answer 1

a. With the fall in the reserve requirement, the money supply will increase. The money supply curve shift from MS to MS1 and lead to the fall in interest rate. It is shown in graph below:

Nominal Interest rate MS MS1 Quantity of Money

b. This will increase the money demand because now people will hold more dollars to transact in the market. This will shift the money demand curve from MD to MD1. This will lead to the rise in interest rate in the market.

Nominal Interest rate MS D1 Quantity of Money

c. With online transaction, now people will have to keep less money with themselves and therefore, the money demand will fall. This will shift money demand curve from MD to MD2. This will lower the interest rate in the market.

Nominal Interest rate MS MD MD2 Quantity of Money