Answer to Question #112451 in Macroeconomics for natasha

Question

Suppose that the money market in Westlandia is initially in equilibrium and the central bank decides to decrease the money supply.
1. Using a diagram like the one in Problem 7, explain what will happen to the interest rate in the short run.
2. What will happen to the interest rate in the long run?

Answer 1

Money supply curve is a vertical curve since the quantity of money in the economy is determined by the Central bank.

1. When the central bank in Westlandia  decreases the money supply, the money supply cure shifts to the left. This raises the equilibrium interest rate in the money market in the short-run.
2. In the long-run, the aggregate price level in the economy will fall. This will in turn reduce the money demand, causing the money demand curve to shift to the left, and the equilibrium interest rate will fall.