Question

Using the money demand and money supply curves, explain how the money market explains the relationship between interest rates and price levels as discussed in the interest rate effect (shape of AD).

Answer 1

There is an inverse relationship between interest rate and price level.

The following things happen step by step:

Step 1) supply of money increases (decreases).

Step 2) it decreases (increases) the interest rate.

Step 3) aggregate demand (AD) increases (decreases), because the cost borrowing money (interest rate) is low.

Step 4) price level increases (decreases), since aggregate supply (AS) don’t change.

Graph:

In the money market, money supply increases from MS0 to MS1. It drops the interest rate from r0 to r1.

Once the money supply increases, it shifts the AD curve to the right as AD1. It shifts the equilibrium from E0 to E1, which tends to increase the price level from P0 to P1.

The reverse things would happen if money supply decreases.