Question

Diagram the effect of each of the following on U.S interest rates. (Show the initial equilibrium in black or blue (pencil or pen). Show the change with an arrow or with a contrasting color. YOU MUST LABEL YOUR AXES AND LABEL THE CURVES.

1. An increase in the rate of economic growth in the United Stated.

2. An increase in the federal budget deficit.

3. An increase in the expected rate of inflation in the United States.

4. A sharp drop in the savings rate by the U.S. households.

Answer 1

Answer-

1.

consider the effects of an increase in real GDP. Such an increase represents economic growth. Thus, the study of the effects of a real GDP increase is the same as asking how economic growth will affect interest rates.

GDP may increase for a variety of reasons and are discussed in subsequent chapters. For now we will imagine that GDP increases for some unspecified reason and consider the consequences of such a change in the money market.

Suppose the money market is originally in equilibrium at point A in the adjoining diagram with real money supply MS/P$ and interest rate i$'. Suppose real GDP (Y$) increases, ceteris paribus.

Again, the ceteris paribus assumption means that we assume all other exogenous variables in the model remain fixed at their original levels. In this exercise it means that the money supply (MS) and the price level (P$) remain fixed. An increase in GDP will raise the demand for money because people will need more money to make the transactions necessary to purchase the new GDP. In other words, real money demand rises due to the transactions demand effect. This increase is reflected in the rightward shift of the real money demand function from L(i$, Y$') to L(i$, Y$").

At the original interest rate, i$', real money demand has increased to 2 along the horizontal axis while real money supply remains at 1. This means that real money demand exceeds real money supply and the current interest rate is lower than the equilibrium rate. Adjustment to the higher interest rate will follow the "interest rate too low" equilibrium story.

The final equilibrium will occur at point B on the diagram. As the interest rate rises from i$' to i$", real money demand will have fallen from 2 to 1. Thus, an increase in real GDP (i.e., economic growth) will cause an increase in average interest rates in an economy. In contrast, a decrease in real GDP ( a recession) will cause a decrease in average interest rates in an economy.

2.

Budget deficits reduce growth by increasing interest rates and diverting private saving from investment to government debt.

3.In order to control high inflation, the central bank increases the interest rate.

4.Savings Drops means less loans available for investments thereore interest rates will increase