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CA Foundation · Business Economics · Money Market

With the money supply fixed by the RBI, the economy's money demand curve shifts to the right because of a rise in national income. Other things remaining equal, what is the effect on the equilibrium interest rate and why?

The equilibrium interest rate rises. Higher income increases transactions demand for money, so at the old rate demand exceeds the fixed supply. People sell bonds to raise cash, bond prices fall, and the interest rate rises until money demand again equals supply.

  1. AIt falls, because people hold more money and bond prices rise
  2. BIt rises, because at the old rate demand for money exceeds supply and people sell bonds to get moneyCorrect
  3. CIt remains unchanged, because money supply is fixed
  4. DIt falls, because transactions demand for money decreases with higher income

Explanation

Higher income raises transactions demand, so at the old rate money demand exceeds the fixed supply. People sell bonds to obtain cash, bond prices fall and the interest rate rises until demand equals supply again. The 'unchanged' option ignores that the demand curve moved.

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