Explain the process by which the money market reaches equilibrium. What impact does a rise in nominal income have on the equilibrium of the money market?
Explain how equilibrium is attained in the money market. How does an increase in nominal income affect the money market equilibrium?
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Equilibrium in the Money Market
Equilibrium in the money market is achieved when the quantity of money demanded equals the quantity of money supplied at a particular interest rate.
Demand for Money: The demand for money is influenced by the interest rate, income level, and transaction needs. It is inversely related to the interest rate; as interest rates rise, the opportunity cost of holding money increases, leading to a decrease in the quantity of money demanded.
Supply of Money: The supply of money is typically controlled by the central bank and is generally considered fixed in the short run.
Equilibrium: Equilibrium is reached at the interest rate where the quantity of money demanded equals the quantity supplied. If the interest rate is above equilibrium, there is excess supply of money, leading to a decrease in interest rates. Conversely, if the interest rate is below equilibrium, there is excess demand, leading to an increase in interest rates.
Impact of Increase in Nominal Income on Money Market Equilibrium
An increase in nominal income shifts the money demand curve to the right, as higher income increases the demand for transactions and precautionary balances.
Shift in Demand: With the money supply constant, the increased demand for money at each interest rate level leads to a new equilibrium with a higher interest rate.
New Equilibrium: The new equilibrium is at a higher interest rate and a higher quantity of money demanded and supplied, reflecting the increased transaction needs of the economy due to higher income levels.