Question

Consider two economies: Discretia and Fixedland. In both countries, banks hold excess reserves. In Discretia, banks hold less in excess reserves as the interest rate increases. In Fixedland, all banks always hold exactly 5% of their checking deposits as excess reserves, regardless of the interest rate. Use the simple model of the money market that we used in class. Suppose the two countries have identical money demand curves, and that the equilibrium interest rate is initially the same in both countries. Then, the central banks of Discretia and Fixedland simultaneously conduct contractionary open market operations of equal magnitude. Will the contractionary open market operation have a greater short-run effect on the interest rate in Discretia or Fixedland? Explain with reference to just one graph.

Answer 1

Don't know what model you used in class but will use model which is generally used in economics. In the below figure Md is demand for money. Mse is initial money supply. Ms1 is money supply in discretia after contractionary monetary policy. Here interest rate rises from io to i1. MS2 IS MONEY SUPPLY IN FIXED LAND. HERE INTEREST RATE RISES FROM IO TO i2. This is because here money supply falls by greater amount than in Discretia where due to excess reserves money supply falls by less amount