Suppose the interest rate is currently 5%. Which of the following statements best explains how the money mark?

Question

Suppose the interest rate is currently 5%. Which of the following statements best explains how the money market moves toward the equilibrium interest rate of 3%? For this problem, ignore any open-economy effects of the policy.

A. The Bank of Canada decreases the money supply, shifting the curve to the left.

B. The Bank of Canada raises interest rates to align with the current rate of 5%.

C. People are unwilling to hold as much money as the Bank of Canada has supplied. This puts downward pressure on interest rates. The curves do not shift.

D. Households need more money for purchases, increasing the demand for money and shifting the curve to the right.

Answer 1

The best explanation is:

C. People are unwilling to hold as much money as the Bank of Canada has supplied. This puts downward pressure on interest rates. The curves do not shift.

Note: If the market rate of interest is higher than the equilibrium rate, the money market and/ or the savings-investment market are in disequilibrium. At the market rate of interest there is higher Saving than Investment demand for funds and therefore interest rates will be under downward pressure in the funds market. In the money market, a higher interest will mean lower liquidity preference and greater demand for converting cash into financial instruments like bonds. This will result in rise in bond prices and hence the effective interest (yield) rates fall.  All this will lead to falling interest rates, elimination of excess Savings and excess holding of liqiud money in the market.

Answer 2

B. The Bank of Canada raises interest rates to align with the current rate of 5%.