Aa Aa 4. The effect of monetary pollcy on aggregate demand Suppose the Federal R

Question

Aa Aa 4. The effect of monetary pollcy on aggregate demand Suppose the Federal Reserve (the Fed") shifts to a contractionary monetary polcy by selling bonds through open-market operations. Assume that thls pollcy is unanticipated. This problem will work through the effects of th move. The following graph shows the money demand and money supply curves. Show the efect of the Fed's contractiona monetary policy by shifting one or both of the curves, and ignore any potential feedback effects. As a result of the Fed's policy, the interest rate rises to 12% Tool tip: Click and drag one or both of the curves. Curves will snap into position, so if you try to move the curve an it snaps back to its original position, just try again and drag it a little farther INTEREST RATE (Percent] 12 Money Supply 10 Money Demand 300 600 900 1200 1500 1800 QUANTITY OF MONEY 1Billions of dallars

Explanation / Answer

In the above example, with monetary contractionary policy, money supply will fall and equilibrium interest rate will rise but it cannot increase to 12% as the money supply would reduce to 0 thus it could increase to 8% or 10% depending on the feds decesion to reduce money supply to 600 or 300.

In the last section, the blanks are as follows

When the Fed sells bonds, the amount of money in circulation in the economy decreases . This drives interest rates up , which causes businesses to invest less in capital improvements like new factories and upgraded equipment. The result is a fall in aggreagate demand, a decrease in the equilibrium price level, and a fall in the equilibrium level of real GDP.

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