Question

Figure 4. On the left-hand graph, MS represents the supply of money and MD represents the demand for money; on the right-hand graph, AD represents aggregate demand. The usual quantities are measured along the axes of both graphs. MS P - - - - - P ...... _I _fr Refer to Figure 4. A decrease in Y from Y1 to Y2 is explained as follows: The Federal Reserve increases the money supply, causing the money-demand curve to shift from MD1 to MD2; this shift of MD causes r to increase from ri to rz; and this increase in r causes Y to decrease from Y1 to Y2. An increase in P from P4 to Pz causes the money-demand curve to shift from MD, to MD2; this shift of MD causes r to increase from ri to rz; and this increase in r causes Y to decrease from Y1 to Y2. A decrease in P from P2 to P1 causes the money-demand curve to shift from MD1 to MD2; this shift of MD causes r to increase from rī to rz; and this increase in r causes Y to decrease from Y1 to Y2. An increase in the price level causes the money-demand curve to shift from MD2 to MD1; this shift of MD causes r to decrease from r2 tori; and this decrease in r causes Y to decrease from Y1 to Y2.

Answer 1

An increase in price from P1 to P2 causes me net demand curve shift from MD1 to MD2; this shift of MD causes r to increase from R1 to R2 and this increase in R causes Y to decrease from Y1 to Y2.

When there is inflation, the money currently held by people is not enough for smooth consumption. Hence, they demand more money for their transactions. With inflation, the real money supply falls. Thus, with shortage of money supply and more money demand, the interest rate rises. This eventually reduces the investment and further the real GDP.