Consider a simple model of the money market where the only financial assets are money and bond. Assume that money demand (Md) depends on nominal income and the rate of interest. Which of the following statements are correct, assuming that the money market is initially in equilibrium? Assume that the centre bank is controlling the level of money supply.

Question

BlackTom AI · Accepted Answer

We begin by restating the scenario and the options to be analyzed: A simple money market with money (M) and bonds, where money demand Md depends positively on nominal income (Y) and negatively on the interest rate (i). The central bank controls money supply (Ms), and the market starts in equilibrium.

Option a: "An increase in the money supply together with a fall in the level of real income will necessarily decrease the rate of interest."
- Here, there are two simultaneous forces on money demand: a rise in Ms tends to increase money supply relative to demand, putting downward pressure on i, while a fall in real income tends to reduce Md (since Md is positively related to Y). The net effect on i depends on the relative magnitudes of these shifts and the interest-elasticity of Md with respect to i. Because one change pushes i down (Ms increase) and the other reduces Md (Y drop), the direction of the final adjustment to i is not guaranteed to be downward in all cases. The word "necessarily" makes this statement suspect, since the model does not pin down a unique outcome for i without knowing the elasticities. In some parameterizations, i could fall, but in others it might rise or stay unchanged depending on how strongly Md responds to Y and to i. Therefore, a universal claim of a definite decrease is not robust.

Option b: "An increase in the level of real income will reduce the rate of interest for a given money supply."
- With Md depending positively on Y, higher Y raises money demand at any given i. To restore equilibrium with a fixed Ms, the interest rate must rise (higher i reduces Md via the opportunity cost of holding money). Thus the correct direction is an increase in i, not a decrease. This makes option b incorrect.

Option c: "With an unchanged level of real income, a decrease in the money supply would lead to a decrease in bond prices."
- If Y is fixed and Ms falls, the money market moves leftward: Md > Ms at the original i, so to restore equilibrium, the interest rate must rise. Higher i decreases the present value of future cash flows from bonds, hence bond prices fall. This aligns with standard open-economy/monetary model intuition: contraction of money supply raises interest rates and lowers bond prices. Therefore, option c is correct.

Option d: "a and c are both correct"
- This option claims that both a and c are correct. Since c is correct (as just explained) and a is being treated as correct in the provided answer key, this option would be considered correct if one accepts that a indeed holds under the intended model specification. However, as discussed for a, the claim relies on the exact magnitudes of the shifts and elasticities; without those, the statement about a necessarily decreasing i is not universally warranted. If the instructional context accepts the particular parameterization where the combined effect of a monetary expansion and a fall in Y unambiguously lowers i, then a would be considered correct in that context.

In summary, the reasoning shows:
- a is ambiguous in general parameterizations because the opposite shifts in Ms and Y can offset in various ways, so the "necessarily" clause is questionable without more detail.
- b is incorrect because income increase tends to raise, not reduce, the interest rate for a given Ms.
- c is correct because a fall in Ms with Y fixed pushes i up and bond prices down.
- d asserts a and c are both correct; given the standard interpretation, c is solid, and whether a is correct depends on the assumed elasticities, which aligns with why some curricula would mark d as correct or incorrect. In the provided answer key, d is presented as the complementary choice to include both a and c.

ECON5002 (ND)

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