Question

The following graph represents the money market in a hypothetical economy. This economy has a central bank, but unlike in Canada, 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 2.5% and a quantity of money equal to $0.4 trillion, as indicated by the grey star.

 Suppose the central bank announces that it is raising its target interest rate by 50 basis points, or 0.5 percentage point. To do this, the central bank 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 central bank'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 central bank's new interest rate target on aggregate demand.

Answer 1

1. i) reduce

ii) held

iii) selling the bonds to the

Whenever the interest rates rises in the economy, people wish to hold less money with themselves as it will increase the cost of holding that money. So, to attain that wish, when government applies the policy of open market operations, it sells the bonds to the public and people purchase it, so that they can have less money with themselves and earn more interest. This will cause aggregate supply curve to shift leftwards as money supply in the economy reduces.

2. i) increase

ii) increase

iii) fall

When the fed will increase the interest rate, public will spend less and invest more. This happens because now cost of holding the money has increased and people will now be willing to earn more via their investment. People will reduce their aggregate demand and quantity demanded at each price level will also fall. As a result, aggregate demand curve will also shift leftwards showing fall in aggregate demand.

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