Question

2. The impact of monetary policy using the AD-AS model 

The following diagram represents the money market in Australia. Imagine that Australia is a closed economy that does not interact with other economies in the world. The money market is currently in equilibrium at an interest rate of 6.00%, and the quantity of money in the economy is $1 trillion, as indicated by the grey star. 

Imagine the Reserve Bank of Australia (RBA) announces that it is lowering its target interest rate by 25 basis points, or 0.25%. To do this, the RBA will use open market operations to sell bonds to the public in order to increase money. 

Use the green line (triangle symbols) on the previous graph to illustrate the effects of this policy by placing the new money supply curve (MS) in the correct location. Place the black point (X symbol) at the new equilibrium interest rate and quantity of money.

Imagine the following graph shows the aggregate demand curve for the Australian economy. The RBA's policy of targeting a lower interest rate will the cost of borrowing, causing residential and business investment spending to a and the quantity of output demanded at each price level. Shift the curve on the graph to show the general impact of the RBA's new interest rate target on aggregate to demand 

Tool tip: Click and drag the curve. The curve will snap into position, so if you try to move the curve and it snaps back to its original position, just try again and drag it a little farther. 

Answer 1

(1) To lower interest rates, RBA will purchase bonds from public to increase the supply of money.

(2) New MS curve as follows.

(3) Policy of lower interest rate will decrease cost of borrowing, causing investment spending to increase and quantity of output demanded to increase.

(4) Higher investment and aggregate demand will shift AD curve rightward as follows.