The Federal Reserve expands the money supply by 5%. a. Use the theory of liquidi
ID: 1249862 • Letter: T
Question
The Federal Reserve expands the money supply by 5%.a. Use the theory of liquidity preference to illustrate in a graph the impact of this policy on the interest rate.
b. Use the model of aggregate demand and aggregate supply to illustrate the impact of this change in the interest rate on output and the price level in the short run.
c. When the economy makes the transition from its short-run equilibrium to its long -run equilibrium, what will happen to the price level?
d. How will this change in the price level affect the demand for money and the equilibrium interest rate?
e. Is this analysis consistent with the proportion that money has real effects in the short run but is neutral in the long run?
Explanation / Answer
first of all we must state that money supply and the interest rate are inversely related. As the money supply increase the interest decreases. This is because when money supply is increased (most likely due to a bank policy) there is desiquilibrium in the money market thus causing it to go back to equilibirum and causing decrease in the interest rate. a) The theory of liquidity preference states that as the interest rate starts to decrease people tend to want their money back from the banks, thus a decrease in the interest rate is going to cause people to retrieve their money from the banks. Thsi can be represented by the IS?LM model. (graph) b) In the short run people will be taking out their money and in doing so increasing the money supply even further, an huge increase in the money supply will tend to lead to inflation and lower unemployment, this will lead to a decrease in aggregate supply and an increase in aggregate demand. c) the price level will increase due to the fact that there is an increase in AD and a decrease in AS, and since short run always has to go back to the long run then it will cause an increase in the price level. d) an increase in the price level will lead to an increase in the demand for money because people will need more to buy less and in doing so the banks will take advantage of people and increase the interest rate on their loans an in doing so decreasing the money supply. e) No, since a monetary expansionary policy lead to an increase in the interest rates and a decrease in the money supply and therefore in affected the long run. hope this helps!!!!!!
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