Household in the UK hold M1 in relation to nominal GDP of about 0.20 in 2015. Suppose that the function k(i) is well- described by the form k(i) = 0,2/i, where l is the nominal interest rate in per cent, and that the interest rate for shot-term non-money bank deposits (the opportunity cost of holding M1) is 1%. Suppose that in the next few years the nominal interest rate rises to 4%.

The real demand for money declined in response to an increase in interest rates. What happens to the supply of money? Draw a graph of before and after, assuming that the central bank is fixing the interest rate 1% and raises it to 4%. Suppose instead that the nominal supply of money is held constant while the interest rate is raised. How could equilibrium be restored? How would your answer change if the price level is fixed instead?