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

Question restatement: 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
- Why this is unlikely: A higher nominal interest rate raises the opportunity cost of holding money, which tends to reduce the quantity of money demanded for transactions and speculative purposes. Therefore, we would not expect the demand for money to increase when the rate rises.
- Regarding the price level: With constant money supply, a fall in money demand could push prices up, but here the premise is that demand for money decreases as interest rates rise, which would more plausibly put downward pressure on the price level rather than upward pressure. Overall this option predicts both demand and price level increasing, which contradicts standard theory where higher interest rates reduce money demand and put downward or ambiguous pressure on prices in the context of money supply fixed.

Option b: increase; decrease
- Money demand: As above, higher nominal interest rates raise the opportunity cost of holding money, so the demand for money should not increase; it should fall or at least not rise.
- Price level: If money demand falls while money supply is fixed, the price level might fall or deflate slightly as fewer dollars circulate in the economy, but the pairing here with an increased money demand makes this option internally inconsistent with the mechanism described, making it unlikely.

Option c: decrease; increase
- Money demand: This aligns with the core idea that higher interest rates discourage holding money, so the demand for money would decrease when the nominal rate rises.
- Price level: With a fixed money supply, a drop in money demand could reduce spending and aggregate demand, exerting downward pressure on the price level rather than upward pressure. This option pairs a decrease in money demand with an increase in the price level, which is inconsistent with the usual transmission mechanism in the money market where lower money demand tends to be associated with lower, not higher, price levels in the short run when the money supply is held constant.

Option d: decrease; decrease
- Money demand: As explained, higher nominal interest rates raise the opportunity cost of holding money, so individuals reduce money holdings, causing the demand for money to fall.
- Price level: With a constant money supply, a reduction in money demand tends to reduce overall spending pressures in the economy. This weaker spending atmosphere can translate into lower price levels or at least weaker inflationary pressure, making a decrease in the price level plausible in the short run under this setup.

Synthesis: The core intuition is that when the money supply is fixed, an increase in nominal interest rates makes holding money more costly, which reduces the quantity of money demanded. Since money in circulation supports expenditures and price levels, a lower money demand tends to ease price pressure, helping push the price level down or keeping it from rising. Among the options, only option d coherently ties together a fall in money demand with a fall in the price level, consistent with the standard quantity theory of money in the short run under a fixed money supply.

Note on consistency and misconceptions: It’s common to confuse the direction of the price level with money demand. Remember that with a fixed money supply, the price level responds to the amount of money people wish to hold and spend. If interest rates rise and people want to hold less money, the reduced spending can lead to lower price pressures. Options a and b predict increases in one or both variables that conflict with the transmission mechanism. Option c correctly describes the direction for money demand but mismatches the expected impact on the price level given a fixed money supply, making it less coherent overall.

BU.220.610.51.FA25 M4 Practice Quiz

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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