Supply of Money and Equilibrium Interest Rate Quiz

The money supply curve is drawn as a vertical line in the Keynesian model because the central bank controls the quantity of money in circulation. Since the money supply is set by policy rather than by market forces, it does not change in response to interest rate movements, making the curve vertical at the fixed quantity supplied.

The answer is True. The central bank has the authority and tools to adjust the money supply, for example through open market operations, changing reserve requirements, or adjusting the discount rate. By increasing or decreasing the money supply, the central bank shifts the money supply curve and thereby changes the equilibrium interest rate in the money market.

A reduction in the money supply shifts the vertical money supply curve to the left. At the original interest rate, money demand now exceeds the available supply. People sell bonds to obtain money, pushing bond prices down and interest rates up. This process continues until the interest rate rises enough to bring money demand back into balance with the reduced supply.

Open market operations are the primary tool through which central banks adjust the money supply. When the central bank buys government securities, it injects money into the economy, increasing the money supply and lowering the equilibrium interest rate. When it sells securities, it withdraws money, reducing the money supply and raising the equilibrium interest rate.

The answer is False. A rightward shift in the money supply curve means the money supply has increased. With money demand unchanged, the higher money supply creates excess money in the economy. People use the surplus to buy bonds, which drives bond prices up and interest rates down. Therefore, an increase in the money supply reduces the equilibrium interest rate, not raises it.

The equilibrium interest rate is determined at the point of intersection between the downward-sloping money demand curve and the vertical money supply curve. At this point, the quantity of money people wish to hold exactly equals the quantity of money available, meaning the money market clears with no excess supply or demand.

The money supply curve is vertical because the central bank determines the fixed quantity of money in circulation. It shifts rightward when the central bank increases the money supply and leftward when it sells securities to reduce the money supply. The slope of the money supply curve is not determined by interest rate changes, as the money supply is independent of interest rates in this model.

When the money supply rises above the demand for money at the current interest rate, people have more money than they wish to hold. They use the surplus money to purchase bonds. This increased demand for bonds pushes bond prices up and interest rates down. The interest rate continues to fall until money demand rises enough to absorb the increased supply.

The answer is False. In the Keynesian money market, the central bank first determines the money supply by setting it through its policy tools. The equilibrium interest rate is then determined by the interaction between this fixed money supply and the money demand curve. The money supply is set first, and the interest rate adjusts as a result.

Quantitative easing involves the central bank purchasing assets to increase the money supply. In Keynesian terms, this shifts the money supply curve to the right. With money demand unchanged, excess money leads people to buy bonds, lowering interest rates. This decline in the equilibrium interest rate is the intended mechanism to stimulate borrowing and economic activity.

An increase in the price level reduces the real value of the existing nominal money supply. This means that people need more nominal money to carry out the same real volume of transactions. With the nominal money supply unchanged, the real money supply effectively falls, creating excess demand for money and pushing the equilibrium interest rate upward.

The answer is False. In the basic Keynesian model, the money supply curve is vertical, not horizontal. A vertical supply curve means the money supply is a fixed quantity determined by the central bank, regardless of the interest rate. A horizontal supply curve would imply the money supply is perfectly elastic, which is not the standard assumption in the Keynesian money market framework.

When the central bank conducts an open market purchase, it buys government bonds from the market. This direct buying increases demand for bonds, pushing bond prices up. As bond prices rise, interest rates fall. At the same time, money is injected into the economy, increasing the money supply. The rise in bond prices and the increase in money supply are two sides of the same central bank action.

When the central bank reduces the money supply, the money supply curve shifts to the left. At the original interest rate, money demand exceeds supply, creating excess demand. People respond by selling bonds to obtain more money, which reduces bond prices and raises interest rates. The interest rate rises until the money market reaches a new equilibrium. The money demand curve itself does not automatically shift in this process.

If the money supply and money demand increase by the same amount and in the same direction, the two changes offset each other. The money market equilibrium remains at the same interest rate because the balance between the quantity of money supplied and the quantity demanded has not changed. The equilibrium interest rate is only affected when supply and demand shift by different amounts.