Question

Suppose a computer virus disables the nation’s automatic teller machines. making withdrawals from bank accounts lessconvenient. As a result, people want to keep more cash on hand, increasing the demand for money.a. Assume the Fed does not change the money supply. According to the theory of liquidity preference, what happens tothe interest rate? What happens to aggregate demand?b. If instead the Fed wants to stabilize aggregate demand, how should it change the money supply?c. If it wants to accomplish this change in the money supply using open-market operations. what should it do?

Answer 1

Interest rate falls

Aggregate demand rises

Increase the supply of money

Buy treasury bills and government bonds

Step-by-step explanation:

1. According to the theory of liquidity preference, when people want to keep more cash it triggers a fall in interest rates because they are no longer willing to keep money in the banks and hence the relationship between demand for money and interest rate is inverse.

2. Aggregate demand rises because people will want to withdraw more cash and keep them because they are not sure when the computer virus issues will be resolved on the ATM's

3. If instead the Fed wants to stabilize aggregate demand, it can increase the supply of money as well in order to create a balance between the forces of demand and supply.

4. Finally, if the Fed wants to accomplish the above change in the money supply using open-market operations, it can do so by BUYING government bonds and treasury bills. This action will release cash into the hands of bill bond holders, increasing the supply of money in circulation.