Using the liquidity preference model, suppose that the stock market crashes and everyone's wealth decreases. What...
Using the liquidity preference model, suppose that the stock market crashes and everyone's wealth decreases. What is the impact on money demand (MD) and the real interest rate (r)?
A MD increases; r increases
B MD decreases; r decreases
C MD increases; r decreases
D MD decreases; r increases
Homework Answers
The answer is: B.) MD decreases, r decreases.
In an instance of a stock market crash, as the prices of stocks decline and everyone's wealth decreases, so does the total money demand as wealth is a major component of money demand. Therefore as wealth decreases the demand for money also declines. Secondly, as the stock market crashes, and public panics and resorts to move their investments in alternatives relatively more safe instruments such as bank deposits, or government bonds, in order to regulate this panic and channel the existing money into the economy and bolster the demand for money the interest rate is likely to decrease as well.
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Using the liquidity preference model, suppose that the stock
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