Deflation and Cautious Banks
The question
In the country of Calder, the aggregate price level falls sharply, so each purchase that households and firms make now takes fewer units of currency. Over the same months, and for reasons unconnected to conditions at home, commercial banks in Calder absorb heavy losses on a portfolio of foreign loans and respond by keeping a much larger share of their deposits as reserves rather than writing new loans. The central bank of Calder has not changed the reserve requirement, the discount rate, or its bond holdings, and real income is unchanged. Show the combined effect of these two events on the money market. Show the effect on the Money Market graph.
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Deflation and Cautious Banks: the worked answer
On the Money Market graph, Money demand (MD) shifts left and Money supply (MS) shifts left.
Why Money demand (MD) shifts left and Money supply (MS) shifts left
Each event moves a different curve. A lower price level means every transaction takes fewer dollars, so the quantity of money households and firms want to hold at each interest rate falls and MD shifts left. Separately, new bank loans create new deposits, and deposits are money, so when banks sit on reserves after their foreign losses instead of lending, less of the money multiplier operates and the total quantity of money shrinks even though no policy tool was used, which shifts the vertical MS line left. The quantity of money is determinate: MS has moved left, and since MS is vertical the equilibrium quantity falls. The equilibrium nominal interest rate is INDETERMINATE. The leftward MD shift pulls the rate down while the leftward MS shift pushes it up, so the outcome depends on the relative sizes of the two shifts: a larger fall in money demand lowers the rate, a larger contraction of the money supply raises it, and equal shifts leave it where it started.
What happens to the equilibrium
The quantity of money definitely falls because the banks' reserve hoarding contracts the vertical MS line, while the equilibrium nominal interest rate is indeterminate and turns on whether the fall in money demand or the fall in the money supply is larger.
The mistake students make on this one
Students overwhelmingly commit to a direction for the interest rate, writing "deflation and a credit crunch, so the interest rate definitely rises" because the contraction feels like tight money. That answer silently ignores the leftward MD shift, which by itself would lower the rate. A second version of the same error is to declare the rate definitely falls after noticing only the deflation, which ignores MS. Neither reading can be defended without a claim about magnitudes that the stem never makes, and the quantity of money is the only outcome whose direction you can state.
On exam day
Assign every sentence of a two-shock stem to a determinant before you draw: a price level change belongs to money demand and a change in bank lending behavior belongs to the money supply, and once the two arrows point the same way you must label the interest rate indeterminate instead of picking the direction that feels contractionary.
How this is graded
The checker reads every curve's position before and after your answer. You are marked correct only when Money demand (MD) shifts left and Money supply (MS) shifts left and every other curve on the Money Market graph stays where it started — the same standard an AP reader applies to a drawn graph: the right shift, and nothing extra. There is no AI involved; the rubric is the geometry.
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