Question

Suppose there is a reduction in aggregate real money demand, that is, a negative shift in the aggregate real money demand function. Trace the short-run and long-run effects on the exchange rate, interest rate, and price level. Explain.

Answer 1

Reduction in aggregate real money demand will cause following impacts:

Exchange rate effect will be the depreciation of home currency. As there is reduction in demand in other words money is in oversupply therefore currency will depreiate to level out the difference.

Interest rate will go down as money is in oversupply there will be fewer borrowers thereby excess reserves therefore interest rates will fall down.

Price level will go up as oversupply of money will cause inflation to shoot up thereby price level will go up so as to level out the gap between demand and supply of money.