Consider the monetary model with zero growth rates of the money supply and the real income in a country. If the real income of the country falls permanently, then the real money balance of the country will be ________ in the long run, other things being equal.

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BlackTom AI · Accepted Answer

We are told to consider a monetary model with zero growth rates for the money supply and real income. The key question asks how the real money balance (M/P) will behave in the long run if real income falls permanently, holding other things constant.

Option a: "higher than before the change". If real income falls permanently, the price level relative to money balances may adjust, but since money supply and real income grow at zero rates in the baseline, a permanent drop in real income reduces transaction demand for money. In the long run, with prices adjusting and no growth in the money stock, the real balance would not rise above its previous level; in fact, the persistent drop in real income lowers money demand, not raises it. Therefore this option is unlikely under the standard quantity theory framework with money-in-the-balloon intuition and stable money stock.

Option b: "the same as before". This would imply that a permanent fall in real income does not affect the real money balance in the long run. However, real money balances respond to changes in real income because money is primarily held to facilitate transactions. A permanent reduction in real income reduces the transactions demand for money, which tends to lower real money balances in the long run if money stock is fixed and there is no compensating change in prices beyond what is needed to clear markets. Hence, keeping everything else equal, this option is not consistent with standard monetary theory.

Option c: "lower than before the change". This option aligns with the intuition that a permanent fall in real income reduces the demand for money for transactions. With money supply growth at zero and real income permanently lower, the real money balance M/P tends to fall to reflect diminished transaction needs, given that prices adjust to equilibrate money demand with the fixed money stock. In the long run, the reduced real income level lowers the transactions demand for money, pulling the real money balance down relative to its previous level.

Option d: "higher than the foreign real money balance". This comparison introduces a foreign benchmark, but the question specifies only the domestic context with zero growth in money supply and real income, not relative exchange rate dynamics or foreign conditions. Without additional information about the foreign economy and their money stock growth or price level, asserting that the domestic real money balance is higher than the foreign one is not determined by the given setup and is not a necessary implication of a permanent fall in domestic real income.

In summary, the most consistent outcome with a permanent fall in real income, under zero growth in money supply and real income, is a lower real money balance in the long run than before the change, since the transactions demand for money declines as real income falls. The remaining options introduce incorrect implications either about being unchanged, rising, or purely comparative without basis in the given framework.

Consider the monetary model with zero growth rates of the money supply and the real income in a country. If the real income of the country falls permanently, then the real money balance of the country will be ________ in the long run, other things being equal.

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