Question

The Federal Reserve may raise the discount rate twice this year. Use the money market model to explain how a higher discount rate would influence the value of money and inflation rate. Draw the graph.

Answer 1

The discount rate is the rate at which the central bank lends to the commercial banks.The discount rate is one of the tools used by the central banks to control the economy by reducing and increasing the money supply in the economy. By increasing the discount rate means the central bank is implementing the contractionary monetary policy by reducing the money supply in the economy. The effect shown by the following graph

When the supply of the money declines people have less money for to do transactions so here the value of the money will rise and the inflation rate will come down. So now less money in hand so they demand few goods and services so the there is the reduction in the demand pull inflation.

I have drawn two sets of graphs , when the Fed increases the discount rate money supply curve shifts to the left and as a result the nominal interest rate will rise in the economy. At the same the reduction in the money supply will negatively affect the aggregate demand, the aggregate demand curve will shift to the left, the price level and the real GDP decreases.