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 5% 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 25 basis points, or 0.25 percentage point. To do this, the Fed will use open- market operations to the money by the public.

Answer 1

Solution: Interest rate = 5%

Quantity of money = $0.4 trillion

Suppose Fed announces that it is lowering its target interest rate by 25 basis points or 0.25% point. To do this, the Fed will use open-market operations to raise/increase the amount/supply of money by purchasing bonds or government securities from the public

Explanation: New Interest rate = 5% - 0.25% = 4.75%

Corresponding to the value 4.75, the money supply = 0.5

New Quantity of money = $0.5 trillion

We can onserve from the graph that quantity of money supplied has been increased from $0.4 trillion to $0.5 trillion.

The money supply is increased by buying bonds from public.