According to liquidity preference theory, the money-supply curve would shift if the Fed A. engaged in open-market transactions. B. changed the discount rate. C. changed the reserve requirement. D. did any of the above. QUESTION 20 Use the following diagram to answer this question Interest rate, r M H ?? Equilibrium interest – ?? rate FL MH M Equilibrium E ML Quantity of money If the money market is initially in equilibrium at point E and the central bank lowers reserve requirements, then the interest rate will: A. move toward point H. B. remain at point E. C. shift leftward. D. move toward point L.
The Correct Answer and Explanation is:
The correct answer is D. move toward point L.
Explanation:
The Liquidity Preference Theory (also known as the theory of the demand for money) suggests that the demand for money is inversely related to the interest rate. In other words, as the interest rate rises, people prefer to hold less money in liquid form (since they can earn more interest by investing it). When the interest rate falls, people demand more money because the opportunity cost of holding it becomes lower.
In this context, the central bank’s actions, particularly lowering the reserve requirements, directly affect the supply of money. When the central bank lowers the reserve requirements for commercial banks, banks have more money available to lend, which increases the money supply in the economy. The money-supply curve shifts to the right.
This rightward shift in the money supply leads to a situation where the quantity of money supplied exceeds the quantity demanded at the original interest rate. To restore equilibrium in the money market, the interest rate must decrease. In the diagram provided, this corresponds to a movement from point E (the initial equilibrium) to point L (a new equilibrium) where the interest rate is lower.
At point L, the quantity of money demanded matches the new, increased supply, and the interest rate stabilizes at this lower level. Therefore, the decrease in the reserve requirements increases the money supply, which in turn lowers the interest rate, shifting the market towards point L.
In summary, a reduction in reserve requirements leads to an increase in the money supply, which lowers the equilibrium interest rate and moves the market toward a new point on the diagram (point L).
