If the money supply is held constant, then an increase in the nominal interest rate will ______ the demand for money and ______ the price level

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BlackTom AI · Accepted Answer

We start by restating the given scenario and what the question is asking. The prompt tells us: If the money supply is held constant, then an increase in the nominal interest rate will ______ the demand for money and ______ the price level.

Option a: "increase; increase" would imply that higher interest rates raise both money demand and the price level. However, when interest rates rise, the opportunity cost of holding money (which earns a zero nominal return) increases, so people tend to hold less money and instead hold interest-bearing assets. This makes the demand for money fall, not rise. Therefore this option misstates the usual relationship between interest rates and money demand, and it also contradicts the typical impact on the price level under the quantity theory in the short run when the money supply is fixed.

Option b: "increase; decrease" suggests that higher nominal interest rates increase money demand while lowering the price level. As explained, higher rates discourage holding money, reducing the demand for money. The assertion that price level falls due to a higher interest rate, with a fixed money supply, is not the direct outcome in the standard framework; the price level is primarily influenced by the real money balances and its relationship with aggregate demand, and with a fixed money supply, expansionary pressure on prices is not generated by higher rates.

Option c: "decrease; increase" posits that higher interest rates reduce money demand (which is correct) but also increase the price level (which is inconsistent with the standard model under a fixed money supply). With the money supply fixed, a decrease in money demand would, if anything, reduce pressure on prices or leave them unchanged in the short run; an increase in the price level is not the direct consequence of a higher interest rate in this setup.

Option d: "decrease; decrease" aligns with the usual analysis: when the nominal interest rate rises, the opportunity cost of holding money increases, so the demand for money falls. If the money supply is held constant, a lower demand for money reduces the pressure on the price level, typically leading to a lower price level or at least not pushing prices up. In many short-run monetary models with a fixed money supply, higher interest rates crowd out spending and reduce inflationary pressure, resulting in a lower price level.

To summarize the logic across options, the central mechanism is the relationship between the opportunity cost of holding money and money demand: higher nominal rates discourage holding money, reducing money demand. With a fixed money supply, this reduction in demand does not push prices up; it tends to ease inflationary pressures or lower prices, making the combination of decreased money demand and a decreased price level the consistent outcome. In contrast, the other options either incorrectly invert the effect on money demand or imply price-level movements that conflict with the fixed-money-supply framework.

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If the money supply is held constant, then an increase in the nominal interest rate will the demand for money and the price level

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