Suppose that the money market in Westlandia is initially in...

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

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

Key Concepts

Short-run vs. Long-run Adjustments

In the short run, with prices assumed to be sticky, a contraction in the money supply results in an immediate rise in the interest rate because the demand for money remains unchanged while the supply decreases. However, in the long run, as prices adjust to the new money supply, the changes in nominal variables can be neutralized, potentially returning interest rates to their prior levels or reflecting new equilibrium conditions based on overall economic adjustments. This distinction highlights the different temporal effects of monetary policy.

Money Market Equilibrium

Money market equilibrium exists where the supply of money, determined by the central bank, equals the demand for money, which is influenced by factors such as income and the interest rate. In this framework, the intersection of the money supply line (usually vertical because it is set exogenously) and the downward sloping money demand curve determines the equilibrium interest rate and quantity of money held by the public.

Monetary Policy and Money Supply

Monetary policy involves actions by the central bank to influence the money supply. A decrease in the money supply, when other factors remain constant, shifts the money supply curve to the left. This reduction in available money increases the equilibrium interest rate as borrowers compete for a scarcer resource. This concept is core in understanding how central bank policy can affect lending rates and, consequently, economic activity.

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