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Discuss how contractionary monetary policy impacts the equilibrium interest rate without talking about bond prices using...

Discuss how contractionary monetary policy impacts the equilibrium interest rate without talking about bond prices using the graph of the money market equilibrium developed in chapter 4.

Please draw it out.
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Answer #1

In money market,an equilibrium is reached when money demand equals money supply.

Money supply is exogenously set by the central bank of a country and is therefore vertical.Money demand is downward sloping due to inverse relation between interest rate and demand for money.

Initial equilibrium is established at point E where the interest rate is i and money demanded is Q.

Now due to contractionary monetary policy,the money supply curve shifts left i.e from MS to MS' and the new equilibrium is reached at point E' where interest rate is i' > i .

Therefore due to contractionary monetary policy, equilibrium interest rate rises to make demand equals to supply.Demand QUond

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