1.13. Because of an economic slowdown, the Federal Reserve Bank of the United States lowered the federal funds rate from 4.25% on January 1, 2008, to 2.00% on May 1, 2008. The idea was to provide a boost to the economy by increasing aggregate demand.

a. Use the liquidity preference model to explain how the Federal Reserve Bank lowers the interest rate in the short run.

Draw a typical graph that illustrates the mechanism. Label the vertical axis “Interest rate” and the horizontal axis

“Quantity of money.” Your graph should show two interest rates, r1 and r2.

b. Explain why the reduction in the interest rate causes aggregate demand to increase in the short run.

c. Demonstrate the effect of the policy measure on the AD curve. Use the LRAS curve to show that the effect of this policy measure on the AD curve, other things equal, causes the aggregate price level to rise in the long run. Label the vertical axis “Aggregate price level” and the horizontal axis

“Real GDP.”