Question

In: Economics

1. Banks introduce overdraft protection, under which funds are automatically transferred from savings to checking as...

1. Banks introduce overdraft protection, under which funds are automatically transferred from savings to checking as needed to cover checks. Ceteris paribus, the change would lead to {AN INCREASE, A DECREASE, NO CHANGE} in demand for M1 and {AN INCREASE, A DECREASE, NO CHANGE} in demand for M2.

2. The stock market crashes, and further sharp declines in the market are widely feared. Ceteris paribus, the financial crisis would lead to {AN INCREASE, A DECREASE, NO CHANGE} in demand for M1 and {AN INCREASE, A DECREASE, NO CHANGE} in demand for M2.

3. Suppose the money market is initially in equilibrium. Show the effects of an open market sale operation on equilibrium i, P, and M in properly labeled money market figures.

Solutions

Expert Solution

(1) The change will lead to no change in demand for M1 (since savings accounts are not included in M1) and an increase in demand for M2 (since savings accounts are included in M2).

(2) The financial crisis would lead to a decrease in demand for M1 (since wealth will fall due to stock market crash, lowering demand for currency/cash) and decrease in demand for M2 (since lower wealth will reduce the investment in savings accounts, time deposits or money market funds).

(3) An open market sale lowers money supply, increasing interest rate and decreasing quantity of money. Higher interest rate will lower investment, reducing aggregate demand and shifting AD curve leftward, lowering price level.

In following graph, MD0 & MS0 are initial money demand & supply curves intersecting at point A with initial interest rate r0 and quantity of money M0. As money supply falls, MS0 shifts left to MS1, intersecting MD0 at point B with higher interest rate r1 and lower quantity of money M1.

In following graph, AD0 & SRAS0 are initial aggregate demand & short run aggregate supply curves intersecting at point A with price level P0 and real GDP Y0. Lower aggregate demand caused by higher interest rate will shift AD0 leftward to AD1, intersecting SRAS0 at point B with lower price level P1 and lower real GDP Y1.

Rahul Sunny answered 2 years ago
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