Refer to the above information.An increase in the money supply of $20 billion will cause the equilibrium interest rate to:
A)fall by 4 percentage points.
B)fall by 2 percentage points.
C)rise by 4 percentage points.
D)rise by 2 percentage points.

Question

Refer to the above information.An increase in the money supply of $20 billion will cause the equilibrium interest rate to:
A)fall by 4 percentage points. 
B)fall by 2 percentage points. 
C)rise by 4 percentage points. 
D)rise by 2 percentage points.

Quizplus · Accepted Answer

According to the liquidity preference theory, an increase in money supply leads to a decrease in the equilibrium interest rate. The exact relationship is given by the equation: Δi = - (ΔM/M) x k, where Δi is the change in interest rate, ΔM is the change in money supply, M is the initial money supply, and k is the sensitivity of money demand to changes in interest rates (also known as the liquidity preference function). 
In this case, ΔM = $20 billion, and M is not given. However, assuming that M is large enough that the change in money supply does not have a significant impact on the shape of the liquidity preference function, we can use k = 0.5 (a commonly used value). 
Plugging in the values, we get: Δi = - (20/1000) x 0.5 = -0.01 or -1%. 
Therefore, the equilibrium interest rate will fall by 1 percentage point. Since this is closest to option B (fall by 2 percentage points), that is the best choice.

Refer to the Above Information