Question

I. Clear and completely labeled graphs.

II. Clear written statements that explain why markets are changing and what the effect of these changes are on equilibrium values and/or the variables of interest. Any additional questions asked must also be answered

1. If the Fed is successful in causing GDP to slow down and this also causes the price level to fall, what will happen to the demand for money?
2. Show what will happen in the market for money.
3. What effect does this have on the interest rate? Does this help the Fed or does it make it harder for the Fed to achieve its goals?

Answer 1

If the Fed is successful in reducing the level of GDP and simultaneously there is a fall in the price level to fall, in the market for money there will be a downward shift of the demand curve because a decline in income will decrease the demand for money.

Due to this shift there is a decline in the rate of interest as well. This occurs because banks are facing excess reserves so the reduce the rate of interest in order to increase the borrowing. But there is no change in money supply so only interest rate falls.

If the goal of Fed is to maintain price stability, then this is achieved because lower rate of interest would stimulate spending which might raise aggregate spending which can mitigate the impact of monetary contraction to some extent.