Question

Assume the demand for money curve is fixed and the Fed decreases the money supply. The result is a temporary a. excess quantity of money demanded. b. excess quantity of money supplied. c. increase in the price of bonds. d. increase in the demand for bonds.

Short answer

The correct answer is \(a\). When the Fed decreases the money supply and the demand for money curve is fixed, it results in a temporary excess quantity of money demanded.

Step-by-step solution

Understanding what happens when supply decreases

The basis of this question lies in understanding the basic principle of economics - the law of demand and supply. According to this principle, when supply decreases while demand stays the same, there is an excess demand for money in the economy. That is, people want more money than there is available.

Applying the Principle of Supply and Demand to the Options

With the background knowledge that a decrease in supply with constant demand leads to more demand than supply, the options can be evaluated. Since we have a situation of excess demand for money, we can directly conclude that option 'a', that is, there will be a temporary excess quantity of money demanded, is the correct answer.

Validate the Answer by Contradicting other Options

Further solidifying the choice, one can look into the other options. If there's a decrease in money supply, there won't be an excess supply of money (option 'b'). As for options 'c' and 'd', the price and demand for bonds are a separate concern which is affected by interest rates and not directly tied to the supply of money in this context. Hence, they can be eliminated. So, the correct answer is 'a'. When there is a decrease in supply of money with the demand for money kept the same, a temporary excess quantity of money is demanded.

Key concepts

Demand for Money

The demand for money is an economic concept that refers to the desire and willingness of people and businesses to hold onto their liquid assets in the form of cash, rather than investing them or buying goods and services. This can be influenced by several factors:

• Transaction Motive: People need money for day-to-day expenses and transactions.
• Precautionary Motive: Holding cash as a safeguard against unexpected expenses.
• Speculative Motive: Holding money to take advantage of future investment opportunities.

Understanding the demand for money is crucial because it helps determine how much money people want to hold at any given time. If the money supply is reduced, but the demand stays the same, as suggested in the original problem, it results in an excess demand for money. This means people are trying to get their hands on more cash than what is available. Such situations can lead to increased interest rates as institutions attempt to quell the broader demand for liquidity.

Law of Supply and Demand

The law of supply and demand is a foundational principle in economics that describes the relationship between the availability of a product or service and the desire for that product or service:

• Supply: This is the total amount of a product or service available to consumers.
• Demand: This is how much people want or need a product or service.
• Equilibrium: This is the point where supply equals demand, stabilizing prices.

When the money supply decreases, as in the example, the amount of money available in the economy is less while demand for it remains unchanged. According to the law, such a situation leads to a higher demand for the limited supply, creating a shortage or excess demand. This can have wide-ranging effects on the economy, including changes in interest rates and investment behaviors.

Federal Reserve (Fed)

The Federal Reserve, often referred to as the "Fed," is the central banking system of the United States. It plays a crucial role in managing the economic stability of the country by controlling the money supply and influencing interest rates. Some key responsibilities of the Fed include:

• Regulating monetary policy: Adjusting the supply of money to stabilize the economy.
• Managing inflation: Keeping inflation under control through various financial tools.
• Acting as a lender of last resort: Providing emergency funds to banks during financial instability.

In the context of the original problem, if the Fed decreases the money supply, it’s likely trying to achieve specific economic objectives, such as controlling inflation or influencing interest rates. This decision affects the demand for money, as less money is distributed among more people or businesses, leading to the situation of excess demand described in the exercise. The Fed's actions are therefore a vital part of understanding supply and demand dynamics and the overall health of the economy.