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IAI Actuarial Core Principles · Business Economics · Role of money and interest rates in the economy

The Reserve Bank of India is assumed to fix the money supply. In a standard liquidity preference diagram, a rise in national income, with money supply unchanged, will lead to which outcome in the money market?

The money demand curve shifts right and the equilibrium interest rate rises. Higher income increases transactions demand at every rate, and with fixed money supply the interest rate must rise to eliminate excess demand for money.

  1. AThe money demand curve shifts right and the equilibrium interest rate risesCorrect
  2. BThe money demand curve shifts left and the equilibrium interest rate falls
  3. CThere is a movement down along the money demand curve and the rate falls
  4. DThe money supply curve shifts right and the rate falls
  5. The money demand curve is unchanged and the rate is unchanged

Explanation

Higher income raises transactions demand at every interest rate, shifting the money demand curve right. With a vertical supply curve fixed by the central bank, the equilibrium rate must rise to restore balance. A movement along the curve would only follow an interest rate change, not an income change.

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