Money Market drawing worksheet
The answer key prints on its own page, so hand out everything before it.
Money Market drawing worksheet · problem 1 of 4
Assume the economy of Valmere is operating below full employment. To stimulate spending, the central bank of Valmere purchases government bonds on the open market. Show the short-run effect of this action on the money market, assuming all else is held constant.
Draw the initial equilibrium, show the change, and label every curve and both axes. Mark the new equilibrium.
Explain your reasoning:
Money Market drawing worksheet · problem 2 of 4
Concerned about rising inflation, the central bank of Orlin raises the reserve requirement that commercial banks must hold against deposits. Show the short-run effect of this action on the money market, assuming all else is held constant.
Draw the initial equilibrium, show the change, and label every curve and both axes. Mark the new equilibrium.
Explain your reasoning:
Money Market drawing worksheet · problem 3 of 4
In the country of Sarelia, nominal gross domestic product rises sharply as both output and the price level increase, so households and firms carry out more transactions each month. Show the effect of this change on the money market, assuming the central bank takes no action.
Draw the initial equilibrium, show the change, and label every curve and both axes. Mark the new equilibrium.
Explain your reasoning:
Money Market drawing worksheet · problem 4 of 4
The economy of Marenza is operating below full employment. To ease credit conditions, the central bank of Marenza lowers the discount rate, the interest rate it charges commercial banks that borrow reserves directly from it. Show the short-run effect of this action on the money market, assuming all else is held constant.
Draw the initial equilibrium, show the change, and label every curve and both axes. Mark the new equilibrium.
Explain your reasoning:
Money Market drawing worksheet: answer key
1. Central Bank Bond Purchase: ms shifts right
An open-market purchase means the central bank buys bonds from banks and pays for them with newly created reserves. Bank reserves rise, so banks can lend more and the money supply increases at every interest rate. Because the central bank sets the money supply, the vertical MS line shifts to the right. Money demand is unchanged because the event does not alter the price level or real income in the short run.
The equilibrium nominal interest rate falls as the quantity of money in the economy increases.
Watch for: The most common wrong answer is shifting MS to the LEFT, because students hear "the central bank is buying" and picture the bank taking money in. The bank pays for those bonds with newly created reserves, so money flows out to banks and the public, which is an expansion of the money supply.
2. Reserve Requirement Change: ms shifts left
A higher reserve requirement forces banks to hold a larger fraction of deposits as reserves, which reduces the money multiplier and the volume of loans banks can create. The total money supply contracts, so the vertical MS line shifts to the left. Money demand stays put because households' transaction needs have not changed.
The equilibrium nominal interest rate rises as the quantity of money in the economy decreases.
Watch for: Many students shift MD left instead, reasoning that "banks are now required to hold more money." A reserve requirement limits how much money the banking system can create, which is the quantity in existence, not how much money households and firms want to hold at each interest rate.
3. Nominal GDP and Transactions: md shifts right
Households and firms hold money primarily to make transactions, and a higher nominal GDP means more and larger transactions at every interest rate. The desired money holdings therefore increase, shifting the MD curve to the right. The money supply is fixed by the central bank, and since the central bank takes no action, the vertical MS line does not move.
The equilibrium nominal interest rate rises while the quantity of money is unchanged.
Watch for: The frequent error is shifting MS right, on the logic that a bigger economy "has more money circulating." The quantity of money in existence is set by the central bank, which the stem says did nothing; a larger volume of transactions changes only how much money people want to hold, so the adjustment happens through a higher interest rate.
4. Discount Rate Cut: ms shifts right
The discount rate is the policy rate the central bank charges banks that borrow reserves from it, not the market rate shown on the graph. Lowering it makes borrowing reserves cheaper, so banks acquire more reserves and expand lending, and the money supply rises at every interest rate. Because the central bank controls the quantity of money, the vertical MS line shifts to the right. Money demand is unchanged because the price level and real income are unaffected in the short run.
The equilibrium nominal interest rate falls as the quantity of money in the economy increases.
Watch for: A large share of students move nothing at all and simply slide down the MD curve, treating the discount rate as if it were the interest rate on the vertical axis. The discount rate is an administered rate that is not plotted on this graph; the rate on the axis is the equilibrium market rate, and it falls only because MS shifted right first.