The following data describe the current conditions in the Money Market Amount of

Question

The following data describe the current conditions in the Money Market

Amount of Money Supplied $100 billion $200 billion $300 billion $400 billion $500 billion $600 billion $700 billion
Interest Rate 7.0% 6.0% 5.0% 4.0% 3.0% 2.0% 2.0%


(a) What happens in this economy if the Amount of Money Supplied increased from $300 billion to $400 billion dollars?

(b) Why would the Central Bank engage in the policy described in (a) above?

(c) What happens in this economy if the Amount of Money Supplied increased from $600 billion to $700 billion dollars?

(d) Describe the effectiveness of Monetary Policy if the Amount of Money Supplied increased from $600 billion to $700 billion dollars

Explanation / Answer

a. If the amount of money supplied is increased from $300 billion to $400 billion , the interest rate decrease from 5 per cent to 4 per cent.

b. The central bank increases money supply which lead to decline in the interest rates to increase the level of investment in the economy which in turn leads to increase in the overall aggregate demand in the economy. This is followed by the Central Bank when the economy is in recession or depression.

c. The interest rate will remain constant and increase in money supply will not have any impact on inflation rate.

d. In this case, the Monetary policy is ineffective. This happens when the money demand function is perfectly elastic at a very low level of interest rate such that the interest rates cannot fall below a certain level even when money supply increases. This is referred as Liquidity trap in Keynesian economics.

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