Question

suppose the fed decreases the discount rate and buys bonds sufficient to increase the money supply by $200 billion. what impact will this have on the interest rate, investment spending, real gdp, and the price level? would that be a good idea in today's economic environment? why or why not? draw graphs to illustrate your points, and describe them and the points thereon thoroughly.

Answer 1

When Fed decreases discount rate and buys bonds, money supply increases, which decreases interest rate. At lower interest rate, investment spending increases, which in turn increases aggregate demand. The AD curve shifts rightward, increasing both price level and real GDP in short run. In current macroeconomic environment where the US is slowly recovering from the financial crisis, a boost in aggregate demand and increasing real GDP will benefit the economy, though inflation will rise.

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

In following graph, AD0 and SRAS0 are initial aggregate demand and short-run aggregate supply curves intersecting at point A with initial price level P0 and initial real GDP Y0. When aggregate demand increases, AD0 shifts right to AD1, intersecting SRAS0 at point B with higher price level P1 and higher real GDP Y1.