Question

1. Using a graph of money market demonstrate what happens to the value of money and the price level if : (10 points)

   (a) The Fed sells government bonds in open-market operation. (b) A decrease in real GDP decreases the demand for money.

Answer 1

a). When the Fed sells the government bonds in the market , it reduces the money supply in the economy and the money supply curve would shift to the left. This is shown by the leftward shift of the money supply curve from MS to MS1 and when this happens the nominal interest rate will increase. The interest rate is the cost of borrwing so this action by the Fed decreases the amount of money held by the public, so the people will limit their consumption and investment spending which decreases the price level in the economy. As the price level decreases the value of money will increase .

b). A decrease in the real GDP decrease the demand for the money and shifts the demand for money curve to the left. A decrease in the money demand means people want to hold less money in their hands , and this will decrease the spending and investment activities so the price level will fall and as the price level falls the value of money increases.