Quizzol

QUESTION:

The following graph represents the money market for some hypothetical economy. This economy is similar to the United States in the sense that it has a central bank called the Fed, but a major difference is that this economy is closed (and therefore does not have any interaction with other world economies). The money market is currently in equilibrium at an interest rate of 3.5% and a quantity of money equal to $0.4 trillion, designated on the graph by the grey star symbol.

Suppose the Fed announces that it is raising its target interest rate by 50 basis points, or 0.5 percentage points. To do this, the Fed will use open-market operations to the money by the public.

Use the green line (triangle symbol) on the previous graph to illustrate the effects of this policy by placing the new money supply curve (MS) in the correct location. Place the black point (plus symbol) at the new equilibrium interest rate and quantity of money.

Suppose the following graph shows the aggregate demand curve for this economy. The Fed's policy of targeting a higher interest rate will the cost of borrowing, causing residential and business investment spending to and the quantity of output demanded to at each price level.

Shift the curve on the graph to show the general impact of the Fed's new interest rate target on aggregate demand.

ANSWER:

Suppose the Fed announces that it is raising its target interest rate by 50 basis points, or 0.5 percentage points. To do this, the Fed will use open-market operations todecrease Correct

thesupply of Correct

money by selling bonds to Correct

the public.

Points:

1 / 1

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 3.5%, as shown by the grey star. If the Fed successfully raises interest rates by 0.5 percentage point, the new intersection of the money supply and money demand curves occurs at an interest rate of 4%. Therefore, you should have placed a green vertical line at the quantity of money that people would demand if the interest rate were 4%. From the graph, you can see that this is $0.2 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 Fed's policy of targeting a higher interest rate willincrease Correct

the cost of borrowing, causing residential and business investment spending todecrease Correct

and the quantity of output demanded to decrease Correct

at each price level.

Points:

1 / 1

Shift the curve on the graph to show the general impact of the Fed's new interest rate target on aggregate demand.

Points:

1 / 1

The Fed uses open-market operations to sell bonds to the public to decrease the money supply and to target a higher interest rate. The higher interest rate increases the cost of borrowing funds to finance residential and business investment. Firms will decrease spending on factories, office buildings, machinery, tools, and equipment. Households will decrease spending on new homes. As overall investment spending decreases, in turn leading to lower consumer spending through the multiplier, the quantity of output demanded decreases at each price level. The decrease in the money supply and the correspondingly higher interest rate cause the aggregate demand curve to shift to the left.

Posted by Cleveland on September 17, 2024