Question

Explain what happens to the interest rate if the money supply increases or decreases and the money demand remains unchanged. Explain what happens to the interest rate if the money demand increases or decreases and the money supply remains unchanged.

Answer 1

Increase in money supply shifts the MS curve rightward to MS'. At new equilibrium e' interest rate decreases to i'.

This happens because when money supply increases quantity demanded for money is less than quantity supplied. To combat the excess supply interest rate decreases so that people demand less bonds and more money.

Increase in money demand shifts the MD curve rightward to MD'. At new equilibrium e' interest rate is higher at i'.

This happens because when money demand increases there is excess demand and to combat the excess demand interest rate increases that encourages people to hold more bonds and less money.