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CA Foundation · Business Economics · Money Market

In the standard model of money market equilibrium, with money supply fixed by the central bank, what happens to the interest rate when the interest rate is above the equilibrium level?

At an interest rate above equilibrium, the quantity of money supplied exceeds the quantity demanded. Holders of surplus money buy bonds, raising bond prices and lowering interest rates, so the rate falls towards the equilibrium level where money demand equals money supply.

  1. ADemand for money exceeds supply, so the interest rate rises further
  2. BSupply of money exceeds demand for money, so the interest rate falls towards equilibriumCorrect
  3. CDemand and supply of money are equal, so the interest rate stays unchanged
  4. DMoney supply automatically falls to match demand while the interest rate stays the same

Explanation

Above the equilibrium rate, people want to hold less money than is available because the opportunity cost of holding money is high. They use the surplus to buy bonds, which raises bond prices and pushes the interest rate down until money demand equals supply. The option claiming the rate rises confuses excess supply with excess demand.

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