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In this hypothetical scenario, lets say money demand exceeds money supply, what would occur if the...

In this hypothetical scenario, lets say money demand exceeds money supply, what would occur if the Federal Reserve did nothing in response to this increase? Why would price levels decrease as a result, and be a bad thing. In the MD and MS graph, would an increase in money demand due to an expected future increase in earnings cause movement along MD curve or a shift, and without a following shift in Money supply, how would that cause price levels to increase?

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Answer #1

Money supply and money demand interact with each other in the money market to determine the market interest rate and the level of real money balances. At the current interest rate assume that market demand for money exceeds the given money supply. This implies that borrowers are demanding more money while there is not enough excess reserves available at the bank. Competition among the borrowers will increase the the rate of interest charged on loans so that banks will now demand a higher rate of interest.

Becauseinterest rate is now increased, the price of bonds will fall. We know that interest rate is negative related with the price level so that when interest rate is increasing the price level of bonds will fall.

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