Assume that the money demand function is (M/P)d = 2,200

Question

Assume that the money demand function is (M/P)d = 2,200 - 200r, where r is the interest rate in percent. The money supply M is 2,000 and the price level P is 2. If the price level is fixed and the supply of money is raised to 2,800, then the equilibrium interest rate will:
A)drop by 4 percent.
B)drop by 2 percent.
C)drop by 1 percent.
D)remain unchanged.

Quizplus · Accepted Answer

Using the money market equilibrium formula: (M/P)d = M/P, we can solve for the initial equilibrium interest rate:
(2,200 - 200r)/2 = 2,000/2
2,200 - 200r = 2,000
-r = -1
r = 1%

With a money supply of 2,800 and the price level fixed at 2, the new equilibrium interest rate can be found by setting the new quantity of money equal to the original money demand function, and solving for r:
(2,200 - 200r)/2 = 2,800/2
2,200 - 200r = 2,800
-r = -3
r = 3%

Therefore, the equilibrium interest rate will drop by 2 percent (from 1% to 3%). The correct answer is B.