Civil Services Prep

Prelims 2013 · Economy · Question 35

Supply of money remaining the same when there is an increase in demand for money, there will be

  1. a fall in the level of prices
  2. an increase in the rate of interest
  3. a decrease in the rate of interest
  4. an increase in the level of income and employment

Answer

an increase in the rate of interest

  • (a) Fall in the level of prices: Not the immediate/direct result in standard money market analysis. With money supply fixed and money demand rising, equilibrium is restored mainly through a higher interest rate. Verdict: Incorrect.
  • (b) Increase in the rate of interest: In liquidity preference theory, when demand for money increases while supply remains unchanged, people try to hold more cash by selling bonds, causing bond prices to fall and interest rates to rise. Verdict: Correct.
  • (c) Decrease in the rate of interest: This is the opposite of what happens when money demand rises with fixed money supply. Verdict: Incorrect.
  • (d) Increase in income and employment: Higher money demand with unchanged supply does not directly raise income/employment; if anything, higher interest rates may dampen investment. Verdict: Incorrect.
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