Which of the following will occur in the money market when the aggregate price level increases?

• A. The demand for money increases.
• B. The supply of money increases.
• C. The demand for money decreases.
• D. The supply of money decreases.

Answer: (A)

Verified step by step guidance

1. Understand the relationship between the aggregate price level and the demand for money. When the aggregate price level rises, the general price of goods and services increases, which means people need more money to carry out the same amount of transactions.
2. Recall the money demand function, which typically depends positively on the price level. Formally, the demand for money \(M^d\) can be expressed as a function of the price level \(P\), real income \(Y\), and the interest rate \(i\): \(M^d = P \times L(Y, i)\), where \(L\) is the liquidity preference function.
3. Analyze how an increase in the aggregate price level \(P\) affects \(M^d\). Since \(M^d\) is proportional to \(P\), an increase in \(P\) leads to an increase in the nominal demand for money, holding other factors constant.
4. Consider the money supply \(M^s\). In the short run, the money supply is typically controlled by the central bank and is fixed at a given level, so it does not automatically change when the price level changes.
5. Conclude that when the aggregate price level increases, the demand for money increases, while the supply of money remains unchanged in the short run.