Last updated: April 27, 2019
Topic: FinanceBank
Sample donated:

1. Hit the `reset` button and make note of the initial values of the money supply, the interest rate, and the level of investment expenditure.

Looking at the initial conditions on figure 1, the money supply Sm=1200, the interest rate i=12%, and the level of investment expenditure I=800.

Figure 1. Initial Conditions

2. What three tools does the Federal Reserve use to increase the Money supply?

1. The conduct of open market operations

2. Changes in the reserve ratio

3. The discount rate.

3. How are these tools used to increase the Money supply?

These tools allows deliberate changes in the money supply to influence interest rates and thereby the level of aggregate spending and employment in the economy. Federal Reserve Bank can buy bonds in open market to increase money supply or sell to decrease money supply. The Federal Reserve Bank has regulatory control over the reserves of banks. By changing the proportion of total assets that banks must hold in reserve with the central bank the Fed can control the amount of loanable funds. This in turn varies the money supply. The Federal reserve can also change the discount rate. The contraction of the monetary supply can be achieved indirectly by increasing the discount rates. When money supply increases, the interest rate falls (as shown in Money Market Graph. When interest rate falls, to compensate for the excess money supply, investment spending increases. Since investment spending is a component of aggregate demand, the aggregate demand curve shifts to the right. When AD shifts to the right, real GDP increases. Consequently if money supply decreases, the complete reverse would occur, the AD shifts to the left, and real GDP decreases.

4. What happened to the interest rate and to Investment when the Money supply is increased to 1500 in the interactive graph?

The interest rate went down to i=10%. The investment went up to I=1000.


Figure 2. Increase in Money Supply


5. As a result of increasing the Money supply, what happens to real GDP and to the Price level?

The GDP increased and the Price level also increases.


6. Give two reasons why the effect of changing the Money supply on real GDP might be less in the real world than is shown in the graph.

GDP is not just consists of Investment impendent but from its other components such as consumption, and export-import. While the graph only shows the control of money supply which directly affects investment spending, exports-imports and consumption may have some opposing response to the monetary policy. For example increasing GDP is only possible at the expense of higher price levels which may reduce consumption. Consequently decreasing prices may only be possible at the expense of lower GDP.

C. MacConnell, S. Brue (2005). Economics: Principles, Problems, and Policies, 16/e. Monetary Policy (Chapter 15.1). Retrieved February 11, 2007 from