The rise in the nominal stock of money causes:

Correct option is B

Correct Answer: B.  A reduction in the equilibrium nominal interest rate and an increase in equilibrium real income.

Explanation: This phenomenon is explained by the IS-LM Model (Investment-Savings / Liquidity preference-Money supply framework) in the short run:

1. Shift in LM Curve: An increase in the nominal money stock (M), assuming the price level (P) is fixed in the short run, increases the real money supply (M/P). This creates an excess supply of money at the prevailing interest rate.

2. Interest Rate Adjustment: To restore equilibrium in the money market, the interest rate must fall. Lower interest rates encourage individuals to hold more cash (speculative demand for money).

3. Income Adjustment: The lower interest rate reduces the cost of borrowing, which stimulates Investment (I). Increased investment leads to higher Aggregate Demand (AD), which in turn leads to an increase in equilibrium real income (Y) (Output).

4. Graphical Result: The LM curve shifts to the right, moving the equilibrium point along the downward-sloping IS curve to a lower interest rate and higher income level.

Information Booster

• Liquidity Effect: The initial drop in interest rates caused by an injection of liquidity is often called the Liquidity Effect.

• Transmission Mechanism: $$Money \ Supply \uparrow \rightarrow Interest \ Rate \downarrow \rightarrow Investment \uparrow \rightarrow Aggregate\ Demand \uparrow \rightarrow Income \uparrow$$.

  Exception (Liquidity Trap): If the economy is in a liquidity trap (horizontal LM curve), increasing the money supply will  not lower interest rates further and will not increase income.

Additional Information

• Option (D): An increase in interest rate and income typically results from an expansionary fiscal policy (IS curve shifts right), not monetary policy.

• Option (A): This describes a contractionary monetary policy (decrease in money supply).