UPSC Prelims 2013 Q85: Indian Economy – Monetary Policy & Money Supply
Supply of money remaining the same when there is an increase in demand for money, there
will be
- (a) a fall in the level of prices
- (b) an increase in the rate of interest
- (c) a decrease in the rate of interest
- (d) an increase in the level of income and employment
Answer: (b) an increase in the rate of interest
Explanation
More demand for money, same supply
The rate of interest is the price of money.
If demand for money rises while supply stays fixed, its price must rise.
| Option | Verdict | Reason |
|---|---|---|
| (a) A fall in the level of prices | Incorrect | Not the direct effect |
| (b) An increase in the rate of interest | Correct | Higher demand, fixed supply |
| (c) A decrease in the rate of interest | Incorrect | The opposite |
| (d) An increase in the level of income and employment | Incorrect | Higher interest tends to reduce investment |
Why people demand money (Keynes):
| Motive | Meaning |
|---|---|
| Transactions | For day-to-day buying |
| Precautionary | For emergencies |
| Speculative | To gain from future changes in bond prices |
This is the liquidity preference theory of interest.
Answer: (b) an increase in the rate of interest.
Why each option is right or wrong
- (a) Incorrect. A fall in prices is not the direct result.
- (b) CORRECT. With fixed supply, more demand for money raises the rate of interest.
- (c) Incorrect. The rate of interest rises, it does not fall.
- (d) Incorrect. Higher interest does not raise income and employment.
Key point
Interest is the price of money: demand up with supply fixed means a higher rate (liquidity preference theory; transactions, precautionary, speculative motives).
Remember
More demand for money = higher interest rate.
Common mistakes
- Confusing demand for money with demand for goods.
- Forgetting that interest is a price.
- Not knowing the three motives for holding money.
Exam tip
Treat money like any good: more demand, same supply, higher price (interest).
Sources
- NCERT Class XII — Introductory Macroeconomics, Ch 3 (Money and Banking)
- J.M. Keynes — The General Theory of Employment, Interest and Money (liquidity preference)