Falling Price Level
The question
In the country of Thessia, the aggregate price level falls sharply during a downturn, so each purchase that households and firms make now requires fewer units of currency. Show the effect of this change on the money market, assuming the central bank takes no action. Show the effect on the Money Market graph.
Drag a curve, or use the arrow buttons. Want the free-play version with every control? Open this graph in the sandbox.
Falling Price Level: the worked answer
On the Money Market graph, Money demand (MD) shifts left.
Why Money demand (MD) shifts left
Households and firms hold money mainly to carry out transactions, and a lower price level means each transaction requires fewer dollars. The quantity of money desired at every interest rate therefore falls, shifting the MD curve to the left. Because the central bank takes no action, the quantity of money it supplies is unchanged, so the vertical MS line does not move.
What happens to the equilibrium
The equilibrium nominal interest rate falls while the quantity of money is unchanged.
The mistake students make on this one
Students often shift MS left because falling prices and a downturn sound contractionary. Nothing here changed the quantity of money the central bank supplies; a lower price level changes only how many dollars each purchase takes, which is a money demand determinant.
On exam day
The price level and money demand always move together: PL up shifts MD right, PL down shifts MD left, and the equilibrium interest rate follows MD in the same direction.
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 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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