AP Macroeconomics Question of the Day

1. The equilibrium nominal interest rate rises from $i_1$ to $i_2$.
2. The equilibrium nominal interest rate falls from $i_1$ to $i_2$. (correct answer)
3. The equilibrium nominal interest rate rises because the money supply curve slopes upward.
4. The equilibrium nominal interest rate rises because saving increases in the loanable funds market.
5. The equilibrium real interest rate falls from $i_1$ to $i_2$ while the nominal rate is unchanged.

Explanation: The money market shows the interaction between money supply (MS) and money demand (MD) to determine the equilibrium nominal interest rate. When the Federal Reserve conducts an open-market purchase of government securities, it buys bonds from banks, increasing bank reserves and thus the money supply—shown as a rightward shift from MS₁ to MS₂. Since the money supply curve is vertical (perfectly inelastic), this represents a fixed increase in the quantity of money at every interest rate. With money demand (MD₁) unchanged, the new equilibrium occurs where MS₂ intersects MD₁, resulting in a lower nominal interest rate (from i₁ to i₂). A common misconception is thinking that more money means higher interest rates, but actually, increased money supply reduces the "price" of holding money (the interest rate). The key strategy: when MS shifts right with MD constant, trace the vertical MS line down to where it meets MD—the interest rate must fall.