A decrease in money supply will likely lead to

Question

BlackTom AI · Accepted Answer

A decrease in the money supply reduces the quantity of money available for transactions and lending, putting upward pressure on market interest rates. 1. Relevant knowledge points and concepts - Money market: with a fixed demand for money, a leftward shift in money supply raises the equilibrium interest rate (liquidity preference model). - Interest rate channel: higher interest rates increase the cost of borrowing and reduce investment (I) and interest-sensitive consumption (C). - Aggregate demand (AD) identity: AD = C + I + G + (X − M). Lower C and I reduce AD, shifting the AD curve leftward. - Alternative frameworks: IS-LM shows a leftward shift of the LM curve (lower money supply) raises interest rates and reduces equilibrium income, consistent with lower AD. 2. Step-by-step reasoning process - Step 1: Central bank decreases money supply (M_s shifts left). - Step 2: For a given money demand, the market equilibrium requires a higher interest rate to clear the money market. - Step 3: Higher interest rates raise borrowing costs for firms and households, so planned investment spending falls; durable-goods and housing consumption also decline. - Step 4: With C and I down, aggregate demand falls, causing an overall decrease in output and price-level pressures in the short run. 3. Intermediate steps (conceptual calculations) - Initial equilibrium: M_s0 -> i0, Y0. - After decrease: M_s1 < M_s0 -> i1 > i0. - Effect on AD: ΔI < 0 and ΔC < 0 => ΔAD < 0 (AD shifts left). 4. Why the correct answer is correct Because a lower money supply directly raises interest rates, and higher interest rates reduce interest-sensitive components of AD (investment and some consumption), aggregate demand decreases. This matches the causal chain described above. 5. Why other options are incorrect - (a) higher rates and an increase in AD: inconsistent—higher rates reduce, not increase, AD. - (b) lower rates and a decrease in AD: wrong sign for rates; a lower money supply raises rates, not lowers them. - (d) lower rates and an increase in AD: describes the effects of an increase in money supply, not a decrease. 6. Conclusion Therefore, the correct answer is c. higher interest rates and a decrease in aggregate demand.

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