Question

Explain how each of the following changes the money supply and the AD. a. b. c. the Fed buys bonds: Money supply ______________________ and AD shifts __________________. the Fed raises the discount rate: Money supply ______________________ and AD shifts __________________. the Fed raises the reserve requirement: Money supply ______________________ and AD shifts __________________.

Answer 1

Answer -

a. Fed buys bonds. Money supply rises and AD`shifts right.

When Fed buys, it pays for it from the money which it creates thereby raises the money supply in the economy. This increase in money supply shifts thus shifts the AD curve to the right.

b. The Fed raises the discount rate. Money supply falls and AD shifts to left.

Discount rate is the rate at which central bank gives loans to the commercial bank. When Fed raises the discount rate, borrowings become expensive. This discourages the businessmen and others from taking loans thereby reducing the flow of credit in the economy. This shifts the AD curve to the left.

c. The Fed raises the reserve requirement: Money supply falls and AD shifts left.  

Reserve requirement is the percentage of the total deposits that the commercial banks have to maintain with the Fed as reserves. When Fed raises the reserve requirement then commercial banks have to keep larger fraction of their deposits as reserves and are left with lesser amount to lend.  Thus money supply falls and AD curve shifts to left.