Question

Assume an economy with ample reserves in the financial sector. Draw a correctly labeled graph of the reserve market.

a) Identify the current equilibrium policy rate (PR)
b) Policy makers at the central bank adjust administered interest rates with the intent of lowering the inflation rate.
Will interest on reserves increase or decrease?
Illustrate on your graph the change that occurs and identify the new equilibrium policy rate (PR1).
c) Will aggregate demand increase, decrease, or remain the same in response to the change in interest rates shown on your graph?

Answer 1

A central bank increases the interest on reserves through open market operations, shifting the supply curve of loanable funds to the left and leading to higher interest rates. This contractionary monetary policy reduces aggregate demand as higher interest rates discourage investment.

Step-by-step explanation:

The discussion involves understanding how a central bank influences interest rates, which is a key concept in monetary policy. When a central bank intends to combat inflation, it may decide to increase the interest on reserves. This is achieved through open market operations where the central bank can change bank reserves, affecting the supply curve of loanable funds. An increase in interest on reserves would shift the supply curve to the left, leading to a new equilibrium with higher interest rates in the market for loanable funds. Consequently, this contractionary monetary policy measure, shown in Figure 28.7, would result in a reduced aggregate demand as higher interest rates generally discourage borrowing and investment, leading to a decrease in economic activity.