Answer to Question #219435 in Microeconomics for henvi

Question

1.    When the central bank decreases the money supply, we expect interest rates

a.     and stock prices to rise.

b.    and stock prices to fall.

c.     to rise and stock prices to fall.

d.    to fall and stock prices to rise.

Answer 1

Solution:

The correct answer is c. to rise and stock prices to fall.

When the central bank decreases the money supply, we expect the interest rates to rise and stock prices to fall.

When the central bank decreases the money supply, households and firms will hold less money than they want compared to other financial assets. Therefore, firms and households will sell other financial assets and withdraw money from interest-paying banks accounts, hence increasing the interest rates.

When interest rates increase, both households and firms will cut back on spending resulting in a drop in earnings and causing stock prices to fall.