Recession and Cash Balances
The question
Real output and real incomes in the country of Solvang fall sharply during a deep recession, and households and firms make far fewer purchases each month. Long-term contracts hold the aggregate price level steady throughout this period, and households' willingness to hold wealth as money rather than bonds is unchanged. 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.
Recession and Cash Balances: the worked answer
On the Money Market graph, Money demand (MD) shifts left.
Why Money demand (MD) shifts left
The principal reason households and firms hold money is to make transactions, and falling real output and real income mean fewer and smaller purchases at every interest rate. With the price level pinned by long-term contracts, the decline in real transactions is the only thing changing desired money holdings, so the MD curve shifts to the left. The central bank takes no action, so the quantity of money supplied is unchanged and 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 frequently shift MS right here, jumping ahead to the rescue they expect the central bank to mount, or shift MS left because a recession simply feels contractionary. The stem says the central bank takes no action, so the only curve that responds to falling real income is MD, and the interest rate falls as a result rather than as a policy choice.
On exam day
Answer the shock in front of you and not the policy response you anticipate: unless the stem says the central bank acts, a change in real income or the price level shifts MD alone.
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.
More Money Market scenarios
Last updated