In the money market, how does an open-market purchase by the central bank affect the nominal interest rate and the money supply?

• A. Money supply increases; LM shifts right; nominal interest rate falls in short run.
• B. Money supply decreases; LM shifts left; nominal interest rate rises.
• C. Money supply unchanged; interest rate unchanged.
• D. Money supply increases; interest rate increases.

Answer: (C)

An open-market purchase by the central bank pushes reserves into the banking system, increasing the money supply. In the money market, more money available at every interest rate means the supply curve for money effectively shifts right (the LM curve shifts right in the IS-LM framework). With higher money supply, the quantity of money demanded at the original rate exceeds supply, so the interest rate falls until money market equilibrates. So, in the short run, the nominal interest rate declines and the money supply rises.