I am unable to understand why the solution to this question is A. Question: Consider an economy where the demand for money balances is interest-elastic and the demand for investment is interest-inelastic. A change in the money supply will result in a relatively: Solution: A small change in the rate of interest and the level of investment. I don't think the solution gave me a good understanding, could someone help, please?
Hi BenNiu, We need to break the analysis down into two: (1) the impact of the change in money supply on the interest rate, and then (2) the impact of the change in interest rate on investment. For (1) the impact of the change in money supply on the interest rate: Try drawing a money market diagram with a really flat (ie interest-elastic) money demand curve, and then shift the money supply curve. Then repeat this with a really steep (ie interest-inelastic) money demand curve. You should see that the first one (flat money demand curve) results in a much smaller change in the equilibrium interest rate. For (2) the impact of the change in interest rate on investment: As the demand for investment is interest-inelastic, this means the level of investment is relatively insensitive to a change in the interest rate, hence a change in interest rate will lead to only a small change in the level of investment. I hope this helps, Richie
