Question

The following graph shows the money market in a hypothetical economy. The central bank in this economy is called the Fed. Assume that the Fed fixes the quantity of money supplied. 

Suppose the price level decreases from 90 to 75. 

Shift the appropriate curve on the graph to show the impact of a decrease in the overall price level on the market for money. 

 After the decrease in the price level, the quantity of money demanded at the initial interest rate of 9% will be _______ money supplied by the Fed at this interest rate. People will try to _______ their money holdings. In order to do so, people will _______  bonds and other interest-bearing assets, and bond issuers will find that they _______ interest rates until the money market reaches its new equilibrium at an interest rate of _______ .

The following graph shows the economy's aggregate demand curve. 

Show the impact of the decrease in the price level by moving the point along the curve or shifting the curve.

 The change in the interest rate that you found previously will cause residential and business investment spending to _______ ,leading to _______ in the quantity of output demanded in the economy.

Answer 1

The price level in the economy decreases from 90 to 75.

When the price level in the economy decreases then households reduce their demand for money.

This reduction in demand for money shifts the demand curve for money to the left.

Following is the required figure -

After the decrease in the price level, the quantity of money demanded at the initial interest rate of 9% will be less than the quantity of money supplied by the Fed at this interest rate. People will try to reduce their money holdings. In order to do so, people will buy bonds and other interest-bearing assets, and bond issuers will find that they can reduce interest rates until the money market reaches its new equilibrium at an interest rate of 6%.

Change in price level will lead to downward movement along the aggregate demand curve as there exists an inverse relationship between the price level and the quantity of output demanded in the economy.

Following is the required figure -

The change in the interest rate that you found previously will cause residential and business investment spending to rise, leading to increase in the quantity of output demanded in the economy.