1
Section – 5.
Q.1 Says law in money market may not hold if supply of money is a function of interest rate (
M M r
=+
). True/False? Explain your answer.
Ans:- TRUE
If money supply is positively related to interest rate and demand for money is negatively
related to rate of interest the money market equilibrium is depicted by the following graph.
In the above graph we measure rate of interest on the vertical axis and money on the horizontal
axis. If central bank increases money supply
MM
the money supply curve will shift towards
the right as depicted in the following graph.
From above diagram it is evident that increase in money demand is less than the increase in money
supply (
1 0 2 1
M M M M AB M M− − = = −
). Hence Say’s law does not hold (supply creates its
own demand, which is the case if
0
=
(prove it)).
Q.2 According to Keynesian theory of money demand, people never hold idle cash. True/False?
Explain your answer.
Ans:- False
According to Keynesian theory an individual will hold bond if and only if
*
t
ii
where
*
i
is that rate of interest (critical rate of interest) at which net return from holding
bonds is equal to zero (
*0ig+=
) where
1
e
t
t t
pp
gp
+−
=
(
p
is price of bond) is capital gain
and loss which occur due to variation in bonds/security prices. On the other hand, an
individual will hold money if
*
ii
