Question

2. Changes in the money supply 

The following graph represents the money market in a hypothetical economy. As in the United States, this economy has a central bank called the Fed, but unlike in the United States, the economy is closed (that is, the economy does not interact with other economies in the world). The money market is currently in equilibrium at an interest rate of 6% and a quantity of money equal to $0.4 trillion, as indicated by the grey star.

Suppose the Fed announces that it is raising its target interest rate by 75 basis points, or 0.75 percentage point. To do this, the Fed will use open-market operations to _______ the _______ money by _______ the public. 

Use the green line (triangle symbol) on the previous graph to illustrate the effects of this policy by placing the new money supply curve (MS) in the correct location. Place the black point (plus symbol) at the new equilibrium interest rate and quantity of money. 

Suppose the following graph shows the aggregate demand curve for this economy. The Fed's policy of targeting a higher interest rate will _______ the cost of borrowing, causing residential and business investment spending to _______ and the quantity of output demanded to _______ at each price level.

Shift the curve on the graph to show the general impact of the Fed's new interest rate target on aggregate demand. 

Answer 1

(1) Fed will use open market operations to decrease the supply of money by selling bonds to public.

(2) Higher interest rate will increase cost of borrowing, causing investment to decrease and quantity of output demanded to decrease.

(3) As a result, aggregate demand will fall, shifting AD curve to left.