Figure 21-2. On the left-hand graph, MS represents the supply of money and MD represents the demand for money; on the right-hand graph, AD represents aggregate demand. The usual quantities are measured along the axes of both graphs. -Refer to Figure 21-2. Assume the money market is always in equilibrium. Under the assumptions of the model, A)the quantity of goods and services demanded is higher at P₂ than it is at P₁. B)the quantity of money is higher at Y₁ than it is at Y₂. C)an increase in r from r₁ to r₂ is associated with a decrease in Y from Y₁ to Y₂. D)All of the above are correct.

Question

Quizplus · Accepted Answer

An increase in r (the interest rate) from r₁ to r₂ shifts the demand for money curve to the left (from MD1 to MD2) since holding money is now more attractive relative to holding bonds (which pay a higher interest rate) and hence, people demand less money. The decrease in the demand for money causes a surplus of money, leading to a decrease in the interest rate to r₂. As a result, investment spending and aggregate demand decrease, leading to a decrease in Y from Y₁ to Y₂. Therefore, option C is the correct answer. Option A is incorrect because the graphs do not provide any information about the quantity of goods and services demanded at different points. Option B is incorrect because the quantity of money is the same at both Y₁ and Y₂ since the money market is always in equilibrium.