Question

2. This question deals with supply and demand for assets. Assume assets supply is perfectly inelastic, which means that changes in price do not change the total supply. Demand for assets is downward sloping, but neither perfectly elastic nor inelastic.

   a. Suddenly and without warning, housing prices rise and homeowners that own homes are wealthier. Use your graph to show what happens to the interest rate.
   b. The federal reserve is expecting a recession to come, so they decide to decrease the cost to banks of borrowing money, making it easier for them to lend. What happens to the interest rates in this economy?

Answer 1

a)

There is a rise in the demand for the money following the housing sector boom. Thus here supply of money remains same but the demand for money curve shifts to right thereby leading to the rise in the interest rates.

The money demand increases Md1 and interest rate rises to the i1.

b)

Recessionary phase leads to the fall in the aggregate demand in the economy. Thus central bank would go for the expansionary monetary policy. Money supply shall rise and interest rate will decline.