Question

The following graph shows the money market in a hypothetical economy. The money supply is currently $200 billion, so the equilibrium interest rate is 0.5%, as shown by the grey star labeled A. Money Supply 0.9 0.8 New MS 0.7 .+ 0.6 INTEREST RATE (Percent) 0.5 Money Demand 0.4 0.3 0.2 0.1 0 800 100 200 300 400 500 600 700 QUANTITY OF MONEY (Billions of dollars)

Answer 1

Interest Rate (Percent) Money Supply New Money supply 0.8 0.7 А 0.5 0.41 Money demand 0-3 0-27 0 100 200 300 400 500 600 700 800 900 Quantity of Money (Billions of dollars)

0.8 Interest Rate Esercent) 0.7 2007 306 Baitial equilibrium 0.5 Now Equilibrium B 0.41 0.3+ Demand for investment. 0-2 → o 50 100 150 200 250 300 350 400 450 investment- (Billions of dollars)

Answer 2

Ans

✓ According to Keyensian view this economy currently in liquidity trap. - False.

The economy is not currently in liquidity trap and at the equilibrium interest rate of 0.5% money demand is still falling. The economy will reach in liquidity trap when interest rate is 0.4%. At 0.4% money demand is almost flat and monetary policy is fully ineffective.

At this situation if Federal Reserve increases money supply by $200 billion.

Interest Rate (Percent) Money Supply New Money supply 0.8 0.7 А 0.5 0.41 Money demand 0-3 0-27 0 100 200 300 400 500 600 700 800 900 Quantity of Money (Billions of dollars)

✓ As a result of the Federal Reserve's action, the equilibrium interest rate decreases to 0.4%.

Because when money supply increases by $200 billion the new money supply becomes $400 billion. With $400 billion money supply given money demand equilibrium will take place at 0.4% interest rate.

0.8 Interest Rate Esercent) 0.7 2007 306 Baitial equilibrium 0.5 Now Equilibrium B 0.41 0.3+ Demand for investment. 0-2 → o 50 100 150 200 250 300 350 400 450 investment- (Billions of dollars)

According to graph of investment demand after taking this monetary expansion equilibrium interest rate will reach at 0.4%. At equilibrium interest rate falls from 0.5% to 0.4% investment demand will increase from $150 billion to $250 New investment demand has been shown by point B in the investment demand curve.

✓ In this case, the Federal Reserve's action stimulates investment. - True.

✓ Keyens argued that if an economy is experiencing a liquidity trap, the government should use fiscal policy to stimulate the economy. This will shift the aggregate demand curve to the right.