Question

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 4% and a quantity of money equal to $0.4 trillion, as indicated by the grey star.?

 Suppose the Fed announces that it is lowering 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 lower 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) When new interest rate = 4% - 0.75% = 3.25%, quantity of money demanded = $0.7 trillion (from money demand curve). Therefore,

Fed will use open market operations to increase the supply of money by buying government securities (bonds) the public.

New money supply curve as follows.

(2) Fed's policy of lower interest rate will lower the cost of borrowing, causing investment spending to rise and quantity of output demanded to rise.

The AD curve will shift rightward as shown below.