Question

Say that investment increases by $60 for each interest rate drop of 1 percent. Say also that the expenditures multiplier is 3. If the money multiplier is 5, and each 5-unit change in the money supply changes the interest rate by 1 percent, what open market policy would you recommend to increase income by $360?

Open market (?) so that the monetary base (?) by $ (?).

Answer 1

(Step - 1)

Required increase in investment ($) = Increase in income / Expenditure multiplier = 360 / 3 = 120

(Step - 2)

When investment rises by $60, interest rate falls by 1%. Therefore, when investment rises by $120, interest rate falls by [($120 / $60) x 1%] = 2%.

(Step - 3)

Money supply and interest rate being inversely related, as interest rate falls by 1%, it implies a $5 increase in money supply. Therefore, as interest rate falls by 2%, it implies a ($5 x 2) = $10 increase in money supply.

(Step - 4)

Finally, Increase in money supply = Increase in monetary base x Money multiplier

$10 = Increase in monetary base x 5

Increase in monetary base = $10 / 5 = $2

Therefore, required Open market policy is:

Open market purchase of government securities so that the monetary base increases by $2.