Question

In a world where the price level could adjust immediately to its new long-run level after a money supply increase
A) The dollar interest rate would increase because prices would adjust immediately and prevent the money supply from rising.

B) The dollar interest rate would remain unchanged because prices would adjust immediately and prevent the real money supply from rising.

C) The dollar interest rate would fall because prices would adjust immediately and prevent the money supply from decreasing.

D) The dollar interest rate would decrease because prices would adjust immediately and prevent the money supply from decreasing.

E) The dollar interest rate would fall because prices would not be able to prevent the money supply from rising.

( PLEASE EXPLAIN THE ANSWER )

Answer 1

It is given that nominal money supply has increased. Price level will also increase immediately because of the long run adjustment. This indicates that there will be no change in the real money supply. This event can be seen as an increase in the rate of inflation which increases the nominal interest rate in order to prevent real interest rate from decreasing which is generally the case when money supply increases and price level does not increase. Hence because of the long run adjustment, on one side there is an increase in the price level so that real money supply does not increase, on the other side there is an increase in the dollar interest rate (nominal) so that real interest rate remains unchanged

Option A is correct