2. If the government wants to increase interest rates in the economy, what kind of open...

2. If the government wants to increase interest rates in the economy, what kind of open market operations should it follow? Describe the full process, along with the impacts on GDP (include graphs)

Solutions

Expert Solution

If the government wants to increase the interest rate, it should decrease the money supply by following contractionary monetary policy (i.e. open market sell of government securities, increase the reserve requirement ratio, increase the discount rate etc.).

Contractionary monetary policy will decrease the money supply in the economy, shifting the money supply curve leftward. As a result, equilibrium interest rate increases.

As interest rate increases, cost of borrowing money for investment increases. Therefore, investment spending will decrease. Also, decrease in money supply decreases Consumption spending. Aggregate demand decreases as a result of decrease in Consumption and investment spending. This will shift the AD curve leftward. As a result, both equilibrium price level and real GDP decrease.

Rahul Sunny answered 1 year ago

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