2. The theory of liquidity preference and the downward-slopingaggregate demand c
ID: 1133661 • Letter: 2
Question
2. The theory of liquidity preference and the downward-slopingaggregate demand curve The following graph shows the money market in a hypothetical economy. The central bank in this economy is called the Fed. Assume that the Fed fixes the quantity of money supplied Suppose the price level decreases from 150 to 125 Shift the appropriate curve on the graph to show the impact of a decrease in the overall price level on the market for money 10 Money Demand Money Supply 15 30 45 60 75 90 MONEY (Billions of dollars) After the decrease in the price level, the quantity of money demanded at the initial interest rate of 6% will be money supplied by the Fed at this interest rate. People will try to and other interest-bearing assets, and bond issuers will find that they new equilibrium at an interest rate of than the quantity of their money holdings. In order to do so, people will bonds interest rates until the money market reaches its The following graph shows the economy's aggregate demand curveExplanation / Answer
After the decrease in the price level, the quantity of money demanded at the initial rate will be lower than the quantity of money supplied by the Fed at the initial rate of interest as with a decrease in the price level, the real money supply will increase and shift money supply curve to the right. People will try to decrease their money holding. In order to do that people will hold more bonds and other interest-bearing assets and bond issuers will find that they will reduce the rate of interest till money market reaches its new equilibrium at 5.1%.
The reduction in the rate of interest would cause investment to rise to lead to an increase in the quantity of output demanded in the economy.
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