Question

If there is a decrease in the money supply, then:

• A. The level of consumption will remain the same.
• B. The level of investment will remain the same.
• C. The level of investment will increase.
• D. The level of investment will decrease.

Hint:

Remember the standard transmission sequence: Money Supply $\downarrow$ $\implies$ Interest Rate $\uparrow$ $\implies$ Cost of Borrowing $\uparrow$ $\implies$ Corporate Investment $\downarrow$.

Answer 1

The Correct Option is D

Step 1: Understanding the Concept:
This question analyzes the monetary transmission mechanism and its impact on interest rates and corporate investments.

Step 3: Detailed Explanation:
Let us trace the chain of economic events when the money supply decreases:
A contraction in the money supply (due to tight monetary policy by the central bank) shifts the money supply curve to the left.
With money demand remaining constant, a decrease in the supply of money raises the equilibrium interest rate in the economy.
Higher interest rates make borrowing more expensive for businesses and households.
When companies evaluate investment projects, a higher cost of borrowing increases the discount rate (hurdle rate), reducing the Net Present Value (NPV) of potential investments.
Consequently, firms postpone or cancel their capital expansion plans, resulting in a decrease in the overall level of investment in the economy.

Step 4: Final Answer:
A decrease in the money supply will lead to a decrease in the level of investment.