Question

1)In the short run, show graphical and explain how does the Fed change the nominal interest rate? 2) In the long Run Show graphical and explain how does the Fed increase or decrease in the quantity of money affects the value of money

Answer 1

1) In the short run, Fed can change the money supply, investment, rate of interest and growth rate of GDP through open market operations. In order to show how Fed change the nominal interest rate, consider a restrictive monetary policy where Fed buys bonds to reduce money supply, In the money market there will be a leftward shift in money supply which raises the nominal rate of interest implies a reduction in investment demand and aggregate demand curve shifts leftwards, hence reducing the level of output.

2) In the long run, it is not necessary that a short-term policy change expansionary or contractionary will definitely impact long-term interest rate. It is a weak link between what Fed desires and how the policy results are implemented. There are situations where investment may not be responsive to change in the nominal rate of interest. This case exists during a recession when demand for goods and services is low, hence it resists Fed's goal to achieve a change in growth rate of GDP as only a long-term change in the rate of interest can create responsiveness in investment. for example, lowering rate of interest means reducing costs and borrowers' profitability to increase by present value calculation.