Question

2. The theory of liquidity preference and the downward-sloping aggregate demand curve

1) Suppose the money market for some hypothetical economy is given by the MD-MS model, which plots the money demand and money supply curves. Assume the central bank in this Fconomy (the Fed) fixes the quantity of money supplied. Suppose the price level increases from 90 to 105 . Shift the appropriate curve on the graph to show the impact of an increase in the overall price level on the market for money.
2) Following the price level increase, the quantity of money demanded at the initial interest rate of 6% will be __ than the quantity of money supplied by the Fed at this interest rate. As a result, individuals will attempt to__their money holdings. In order to do so, they will__bonds and other interest-bearing assets, and bond issuers will realize that they__interest rates until equilibrium is restored in the money market at an interest rate of__
3) The AD graph plots the aggregate demand curve for this economy. Show the impact of the increase in the price level by moving the point along the curve or shifting the curve. The change in the interest rate found in the previous task will lead to a__ in residential and business spending, which will cause__ in the quantity of output demanded in the economy.

Answer 1

An increase in the price level from 90 to 105 will cause a rightward shift in the money demand curve due to the theory of liquidity preference since more money is needed for transactions. At an initial interest rate of 6%, the quantity of money demanded exceeds the supply, and individuals will sell bonds, causing bond issuers to increase interest rates. The AD curve will demonstrate a decrease in the quantity of output demanded due to higher interest rates.

Step-by-step explanation:

When the price level increases in an economy, this means that the value of money effectively decreases in terms of what it can purchase. According to the theory of liquidity preference, if the price level increases from 90 to 105, the demand for money at the current interest rate will increase because people will need more money to carry out their transactions. This is depicted by a rightward shift in the money demand curve in the MD-MS model. Since the supply of money is fixed by the central bank, the quantity of money demanded at the initial interest rate is greater than what is being supplied. This excess demand for money at an interest rate of 6% will lead individuals to decrease their money holdings by selling bonds and other interest-bearing assets. Bond issuers will then need to increase interest rates to restore equilibrium in the money market.

In terms of the aggregate demand (AD) curve, an increase in the price level, coupled with higher interest rates, leads to a decrease in spending on investments and possibly consumption due to the interest rate effect. This will cause a movement up along the AD curve, showing a decrease in the quantity of output demanded at the higher price level. The wealth effect and the foreign price effect are also contributing factors to the downward slope of the AD curve, but they are not explicitly mentioned in relation to the change in the price level from 90 to 105 in this scenario.

Answer 2

The quantity of money demanded increases with the price level, causing the money demand curve to shift, and interest rates to rise. This movement along the aggregate demand curve results in decreased residential and business spending, and consequently, a reduced quantity of output demanded in the economy.

Step-by-step explanation:

The theory of liquidity preference and the aggregate demand (AD) curve explain how different economic factors influence the overall demand in an economy. When the price level increases, the money demand curve shifts rightward because people need more money to conduct transactions. In response to a rise in the price level from 90 to 105, the quantity of money demanded at the initial interest rate of 6% will be greater than the quantity of money supplied by the Fed at this interest rate. As a result, individuals will attempt to increase their money holdings. They will do this by selling bonds and other interest-bearing assets, leading to an excess supply of bonds. To restore equilibrium, bond issuers must increase interest rates.

Consequently, the AD graph should show a movement along the curve to a higher price level and a decrease in the quantity of output demanded. As the interest rate rises following the price level increase, there will be a decrease in residential and business spending, thus leading to a reduction in the quantity of output demanded in the economy.