Question

Suppose a computer virus disables the nation's automatic teller machines, making withdrawals from the bank accounts less convenient. As a result, people want to keep more cash on hand, increasing the demand for money.

a. Assume the Fed does not change the money supply. According to the theory of liquidity preference, what happens to the interest rate? What happens to aggregate demand?

b. If instead the Fed wants to stabilize aggregate demand, how should it change the money supply?

c. If it wants to accomplish this change in the money supply using open-market operations, what should it do?

Answer 1

a. Assume the Fed does not change the money supply. According to the theory of liquidity preference, what happens to the interest rate? What happens to aggregate demand?

According to the theory of liquidity preferences, Rate of interest is demand by the supply of and demand for money. The rate of interest on the demand side is governed by the liquidity preference of the community arises due to the necessity of keeping cash for meeting certain requirements. Hence, if making withdrawals from bank accounts less convenient, Money demand will increase shifting the money demand curve upwards. With supply constant, Interest rate will increase to maintain equilibrium in the money market.

b. If instead the Fed wants to stabilize aggregate demand, how should it change the money supply?

If the Fed wants to stabilize aggregate demand, it should increase money supply. This brings rate of interest back open market operation is the method of buying or selling government securities in the market. When the Fed restore to the method of open market operations, it will increase the money supply by buying government securities in the market. When the government buys securities or bonds, money is transferred from the government to the hands of the public increasing supply of money.

c. If it wants to accomplish this change in the money supply using open-market operations, what should it do?

In this case, there will be a shortage of money and the aggregate demand will go up. With this increase in demand, the FED will lower the interest rates to reduce the amount of people from borrowing money. This will eventually result in the economy moving back to equilibrium where the quantity of money supplied meets the quantity demanded.