Question

# Use the following table to answer the next question. The money supply and investment are in...

Use the following table to answer the next question. The money supply and investment are in billions. Money Supply (billions of dollars) Interest Rate Investment (billions of dollars) \$50 7% \$100 60 6 110 70 5 120 80 4 130 90 3 140 Assume that the MPC is 0.9 and the reserve requirement is 0.2. If the Federal Reserve needs to increase aggregate demand by \$100 billion at each price level to move the economy back to full employment and the current interest rate is 6%, then the Federal Reserve should _________ bonds on the open market equal to ________. rev: 06_20_2018 Multiple Choice buy, \$4 billion sell, \$4 billion buy, \$2 billion sell, \$2 billion

 Money Supply (billions of dollar) Interest rate (%) Investment (Billions of Dollar) 50 7 100 60 6 110 70 5 120 80 4 130 90 3 140

Current interest rate is 6%.

It means current investment is \$110 billions

and current money supply is \$60 billions.

MPC = 0.9

Spending multiplier = 1 / (1 -MPC) = 1 / (1 - 0.9) = 1/0.1 = 10

There is need to increase the aggregate demand by \$100 billion at each price level.

=> Change in AD = \$100 billion.

Spending multiplier = Change in AD / Change in investment level.

=> 10 = (\$100 billion / Change in investment level)

=> Change in investment level = (\$100 billion / 10)

=> Change in investment level = \$10 billion

There is need to increase the investment level by \$10 billion. Thus,the investment level will increase form \$110 billion to \$120 billion.

In order to get the investment level of \$120 billion, interest rate should falls to 5%.

In order to decrease the interest rate to 5%, there is a need to increase the money supply from \$60 billion to \$70 billion. Hence, there is a need to increase the money supply by \$10 billion.

Federal reserve should conduct the open market purchase of government bonds in order to increase the money supply.

Money multiplier = (1 / reserve resquirement ratio) = (1 / 0.2) = 5

Purchase of government bonds = (Increase in money supply / Money multiplier)

=> Purchase of government bonds = (\$10 billion / 5)

=> Purchase of government bonds = \$2 billion

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