Question

Say that investment increases by $20 for each interest rate drop of 1 percent. Say also that the expenditures multiplier is 3 . If the money multiplier is 4 , and each 5-unit change in the money supply changes the interest rate by 1 percent, what open market policy would you recommend to increase income by $240 ? Open market __________ so that the monetary base ________ by $____

Answer 1

An open market purchase is recommended to increase the monetary base by $5 to achieve a $240 increase in income.

Step-by-step explanation:

To increase income by $240 with a given expenditures multiplier of 3, we need an initial investment increase of $240 / 3 = $80. Given that investment increases by $20 for each 1 percent drop in the interest rate, we need the interest rate to drop by $80 / $20 = 4 percent.

Since the money multiplier is 4 and each 5-unit change in the money supply changes the interest rate by 1 percent, a change of 4 percent in interest rate requires a change in the money supply of 4 percent x 5 units/percent = 20 units.

The relation between the money supply and monetary base is given by the money multiplier, so to change the money supply by 20 units, the monetary base must change by 20 units / 4 (money multiplier) = 5 units.

Therefore, to increase income by $240, an open market purchase should be recommended so that the monetary base increases by $5.