Because of the economic slowdown associated with the 2007–2009 recession, the Federal Open Market Committee of the Federal Reserve, between September 18, 2007, and December 16, 2008, lowered the federal funds rate in a series of steps from a high of 5.25% to a rate between zero and 0.25%. 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 Open Market Committee 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. Suppose that in 2015 the economy is at potential output but that this is somehow overlooked by the Fed, which continues its monetary expansion.

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.”