Question

1. In response to the COVID-19 outbreak, the Bank of Canada has cut the key interest rate by 50 basis points to help stimulate the economy. (Chapter 28) Complete the following:
   1. Graph the decline in interest rate and discuss what happened.
   2. What parts of the AE function are effected and how? Graph the change in the AE model.
   3. Graph the AD/AS function and close the gap. What gap was closed? What is expected to happen to GDP and price levels as a result of the interest rate cut?

Answer 1

a) We can show the decline in interest rate on Money supply-money demand diagram. A cut in interest rate leads to increased lending by commercial banks, hence, an increase in money supply. Given the money drmand an increase in money supply pushes the interest rate downward and hence, leads to decrease in market interest rate.

On the graph, earlier the money market was in equilibrium at level L of real money and i market interest rate. A cut in key interest rate leads to rightward shift in money supply curve to M’ from Ms, this leads to a decrease in interest rate to i’ and increase in real money to L’.

b) A fall in interest rate to i’ leads to an increase in private investment which increases the output Y to Y’. On the graph, this decrease in interest rate leads to upward shift in AE curve to AE’ leading to increase in output from i to i’

c) On the AS curve due to corona outbreak, output is below the natural level of output Y’. A cut in key interest rates lead to increase in real money supply which leads to a rightward shift of AD curve to AD’ and output is back to natural level of output Y’ and price level increases from P to P’. The gap here is the gap between the current level of output Y and natural level of output Y’. Thus, this policy increases the output (or GDP) and the price level too.

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