In the context of the money market, how does an increase in the overall price level affect nominal interest rates?

• A. It has no effect on the demand for money or nominal interest rates.
• B. It increases the demand for money, leading to higher nominal interest rates.
• C. It decreases the demand for money, resulting in lower nominal interest rates.
• D. It increases the supply of money, causing nominal interest rates to fall.

Answer: (B)

Verified step by step guidance

1. Understand the relationship between the price level and the demand for money: When the overall price level increases, people need more money to carry out the same amount of transactions because goods and services are more expensive.
2. Express the demand for money as a function of the price level: The demand for money (Md) is proportional to the price level (P) and real output (Y), often written as \(M^d = P \times L(Y, i)\), where \(L\) is the liquidity preference depending on income and nominal interest rate \(i\).
3. Analyze the effect of an increase in the price level on money demand: An increase in \(P\) shifts the money demand curve to the right because people want to hold more nominal money balances to maintain their purchasing power.
4. Consider the money supply as fixed in the short run: Since the nominal money supply (\(M^s\)) is fixed by the central bank, the increase in money demand creates excess demand for money at the initial nominal interest rate.
5. Determine the impact on nominal interest rates: To restore equilibrium in the money market, the nominal interest rate must rise, which increases the opportunity cost of holding money and reduces money demand back to the available supply.