The Influence of Monetary and Fiscal Policy on Aggregate Demand 3

# The Influence of Monetary and Fiscal Policy on Aggregate Demand 3

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Unformatted text preview: 3. Changes in ﬁle money supply 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 of6% and a quantity ofmoney equal to \$0.4 trillion, as indicated bythe grey star. .4, Correct Answer Your Answer 8D qr "l5 NewMSCurve MoneyDemand H] r: “I- E 3 E 6-5 Nequuilibrium E '3: 6.0 n: 5 m 5.5 LIJ ._ E 5D 4.5 Mone Su | 4.0 Y WY [1 {1.1 {1.2 {1.3 {1.4 {1.5 {1.6 {1.7 {1.3 MONEYt‘I'riIIionsofdollars] 5 Points: _ 0.5 i 1 Suppose the Fed announces that it is raising its target interest rate by 25 basis points, or 0.25 percentage point. To do this, the Fed will use open— market operations to decrease V the supply of V money by selling bonds 130 V the public. ﬁPoints:—1l1 Use the green line {triangle symbol) on the previous graph to illustrate the eﬂﬁects of this policy by placingI the new money supply curve (MS) in the correct location. Place the black point {plus symbol) at the new equilibrium interest rate anar quantity of money. Explanation: Close Explanation A The Fed controls interest rates by changing the money supply, taking the position of the money demand curve as given. Before the Fed's action, the interest rate was 6%, as shown by the grey star. If the Fed successfully raises interest rates by 0.25 percentage point, the new intersection of the money supply and money demand curves occurs at an interest rate of 6.25%. Therefore, you should have placed a green vertical line at the quantity of money that people would demand if the interest rate were 6.25%. From the graph, you can see that this is \$0.3 trillion. To decrease the money supply, the Fed will use open—market operations to sell bonds to the public. when the Fed sells bonds to the public, the reserves in the banking system decrease, and banks' ability to lend money decreases. Suppose the following graph shows the aggregate demand curve for this economy. The Feds policy oftargeting a higher interest rate will increase V the cost of borrowing, causing residential and business investment spending to decrease V and the quantity of output demanded to decrease V at each price level. ﬁPoints:—1l1 Shirt the curve on the graph to show the genera! impact ofthe Fed's new interest rate target on aggregate demand. PRICE LEVEL ﬁrm OUTPUT _o_ Aggregate Demand 4' ...
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