Question

1. Consider the market for real money balances. Suppose the Chinese economy begins to desacelerate (i.e., it begins to enter a recessionary period) causing aggregate output to decrease.
   1. Assuming that the price level does not change, with the help of a graph describe the effect on the interest rate if the Central Bank of China decides to increase the money supply at the same time that aggregate output decreases.
   2. Assuming the price level decreases and the money supply does not change, with the help of a graph describe the effect on the interest rate at the same time that aggregate output decreases.

Answer 1

a. The Money supply is vertical and is fixed by the central bank. This is M1/P vertical line. Money demand is downward sloping and is dependent of output and interest rate. As output and hence income falls, people demand less money and money demand curve shifts downwards causing interest rate to decrease from r1 to r'. At the same time when money supply increases from M1/P to M2/P, the interest rate falls down further to r2.

b. The money supply line is also the real money balance line - M/P1. When price decreases, the same money buys more goods and services, meaning an increase in real money balance to M/P2. The fall in money demand decreased interest rates to r' while the rise in real money balance due to price decline lead to further fall in interest rate to r2.