Question

Suppose that each 0.1-percentage-point increase in the equilibrium interest rate induces a $3 billion decrease in real planned investment spending by businesses. In addition, the investment multiplier is equal to 5, and the money multiplier is equal to 3. Furthermore, every $10 billion decreases in the money supply bring about a 0.1-percentage-point increase in the equilibrium interest rate. Use this information to answer the following questions under the assumption that all other things are equal.

Calculate by how much the real planned investment must decrease if the Federal Reserve desires to bring about a $60 billion decrease in the money supply level.

Answer 1

Answer and Explanation:

(1) Decrease in investment = Decrease in money supply / Investment multiplier

= $60 billion / 5 = $12 billion

Real planned investment will decrease by $12 billion

The Federal Reserve decreased money supply by 60 billion and we wish to determine by how much this would affect real planned investment. We have therefore applied the investment multiplier to determine decrease in real planned investment. This is based on Keynes' theory of investment multiplier