1. explain 2 factors that”can limit the Fed’s control of the money supply. 2.explain tge “interest...

1. explain 2 factors that”can limit the Fed’s control of the money supply.

2.explain tge “interest rate effect” on the slope of the AD curve

3. explain the “ theory of liquidity preference”

a) how does it explain tge downward slope of the aggrgate demand curve?

b) how would a decreae in money supply affect the aggregate demand curve ?

Expert Solution

(1)

Fed can increase (decrease) money supply by open market purchase (sale) of government securities, by lowering (raising) discount rate or by lowering (raising) reserve ratio. However, Fed cannot precisely control the magnitude of change in money supply for following reasons:

(a) If people decide to retain higher (lower) proportion of their money as currency, the drainage ratio increases (decreases), which decreases (increases) money supply relative to Fed's intended change in money supply.

(b) If commercial banks keep higher (lower) proportion of their total reserves as excess reserves (without lending it), the excess reserves ratio increases (decreases), which decreases (increases) money supply relative to Fed's intended change in money supply.

(2)

When price level rises (falls), purchasing power falls (rises), so people demand more (less) money. Higher (lower) demand for money shifts the money demand curve rightward (leftward), and money supply remaining unchanged, interest rate rises (falls). Higher (lower) interest rate decreases (increases) investment and interest rate-sensitive portion of consumption demand, which decreases (increases) the quantity of real GDP demanded, giving the AD curve a negative slope.

NOTE: As per Answering Policy, 1st 2 questions are answered.

Rahul Sunny answered 1 year ago

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