11 Explain the adjustment process in the money market that c

11. Explain the adjustment process in the money market that creates a change in the price level when the money supply increases. 12. Using separate graphs, demonstrate what happens to the money supply, money demand, the value of money, and the price level if: a. the Fed increases the money supply. b. people decide to demand less money at each value of money.

Solution

11) increase in money supply leads to decrease in interest rate to combat excess Demand for money. Decrease in interest rate implies a decrease in cost of borrowing. Decrease in cost of borrowing leads to increase in investment. Since investment is a part of aggregate demand. Thus higher investment leads to increase in aggregate demand. But aggregate supply being constant, higher demand leads to higher prices.

Thus as money supply increases price level also increases.