Question

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

Answer 1

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

Answer: Buy $2 billion