Question

2) Consider an increase in money demand brought about concerns over cyberattacks on financial markets.

a) Explain what happens to real interest rates and output if the Federal Reserve does nothing.

b) Suppose the government decided to combat the effects in part (a) by cutting taxes and increasing government expenditures. Can these policies undo both effects from part (a)?

Explain why or why not.

Answer 1

Part a) If the Federal Reserve does nothing to tackle the increased demand for money, then given the money supply the real interest rates will increase. As the real interest rates increase the investment demand will fall. This is because now it will become expensive for the firms to borrow from the market.

Decline in investment will cause the output to decline.

Part b) If the government decides to combat the effects of increased demand for money by cutting taxes and increasing government spending then both output and interest rates will increase.

Government action will raise the level of income/output in the economy for a given level of money supply and interest rates. Increase in the income will raise the transaction demand for money, as a result people will start to withdraw money from their speculative balances. To keep the money market in equilibrium the interest rates will increase further. Increase in the interest rates will further reduce the investment level in the economy.

So, in the end output will increase, interest rates will increase, investment will decline, and the share of government in the total output will increase.