Answer to Question #175389 in Macroeconomics for zoo

Question

A2-5. Suppose a central bank decides to decrease its policy interest rate in an effort to decrease interest rates throughout the economy. 

1. (a) Using a diagram for the money market, explain the effects of the decision on interest rates and how the central bank must respond to support this policy decision. [Hint: make sure to discuss the adjustment to the new equilibrium in the money market.] [5] 
2. (b) Suppose the economy is a closed one. What effect will the policy change have on investment, on aggregate expenditure? Include diagrams in your answer. [5] 
3. (c) What additional effect will there be on aggregate expenditure if the economy was an open one? [5] 
4. (d) How will aggregate demand be affected, whether we treat the economy as closed or open? (Illustrate in a diagram.) Under what circumstances would this policy be appropriate for a central bank that was trying to stabilize the economy? (Illustrate in your diagram.) [5] 

Answer 1

(a) The central bank may decrease the reserve ratio or conduct an open market purchase to increase the money supply and as a result decrease the equilibrium interest rate.

(b) If the economy is a closed one, then this policy will increase both investment and aggregate expenditure, increasing the equilibrium output and price level.

(c) As an additional effect the exports and foreign investment would increase boosting the aggregate expenditure if the economy was an open one.

(d) The aggregate demand will increase and shift to the right whether we treat the economy either as closed or open. This policy would be appropriate for a central bank to stabilize the economy, if it is in a recession and the inflation is low.