Suppose the FED has complete control on the supply of money, so if the FED decreases the money supply,

Question

BlackTom AI · Accepted Answer

A decrease in the money supply causes the market interest rate to rise.

1. Relevant knowledge points and concepts
- Money market equilibrium: money supply (set by the Fed) equals money demand (a function of income and the interest rate).
- Money supply is vertical (fixed) in the short run; money demand falls with higher interest rates (opportunity cost of holding money).
- Interest rates adjust to equilibrate money supply and money demand. When money is scarce, people sell interest-bearing assets (bonds), pushing bond prices down and yields (interest rates) up.

2. Step-by-step reasoning
- Start at an initial equilibrium: money supply MS0 intersects money demand MD at interest rate i0.
- The Fed decreases money supply from MS0 to MS1 (a leftward shift).
- At the original interest rate i0, money demand MD exceeds the new money supply MS1, so there is a shortage of money.
- To obtain liquidity, holders of nonmoney assets (e.g., bonds) sell them, increasing bond supply.
- Increased bond supply lowers bond prices. Because the interest rate (yield) is inversely related to bond price, yields (market interest rates) rise.
- The interest rate rises to a new equilibrium i1 where money demand equals the reduced money supply MS1.

3. Intermediate steps (logical transaction sequence)
- MS ↓ → money shortage at i0 → people sell bonds → bond prices ↓ → interest rates (yields) ↑ → new equilibrium where MD(i1) = MS1.

4. Why the correct answer is correct
- The Fed’s reduction of the money supply directly reduces liquidity. The only market-clearing mechanism is an adjustment of the interest rate upward, which lowers money demand until it matches the smaller supply. This is standard monetary theory (liquidity preference).

5. Why the other options are incorrect
- “The interest rate will decrease”: incorrect because reduced money supply makes money scarcer, not cheaper; lower supply raises the price of borrowing (interest rates).
- “The interest rate will not be affected”: incorrect because with money demand positively responsive to liquidity costs, the shortage forces an interest rate adjustment except in implausible corner cases.

6. Conclusion
The interest rate will increase, which matches the provided correct answer: “the interest rate will increase.”

Suppose the FED has complete control on the supply of money, so if the FED decreases the money supply, 单项选择题

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