Question

Answer True or False. Briefly explain your answer and use the proper diagram when needed. No credit without explanation.

1. b (15 points) True or False: Under sticky prices, an increase in the money supply cause an increase in the interest rate to preserve the money market equilibrium. Support your answer with a graph of the money market and with the money market equilibrium equation.

Answer 1

Money market equilibrium equation:

money supply= money demand

M/P= hY-ki

M= nominal money; P=price level; Y= income; i= interest rate; h and k are constants

Now, it is given that money supply increases, so that M in left hand side rises. Since price is sticky, P does not rise. To maintain equilibrium, either Y has to increase or i has to fall. Since Y is constant is short term, equilibrium is maintained by falling interest rates. Hence, statement is false.

Money market equilibrium is graphed below:

Ms1 is money supply curve before increase. Ms2 is money supply curve after increase. Since money demand does not change. An increase in money supply (without increase in price), leads to fall in interest rates.