Because of the economic slowdown associated with the 2008-2009 recession, the Governing Council of the Bank of Canada, between December 4, 2007 and April 21, 2009, lowered its target for the overnight interest rate in a series of steps from a high of 4.5% to a rate of 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 BOC Governing Council 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, i₁ and i₂.

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

c. Suppose that in 2016 the economy is at potential output but that this is somehow overlooked by the BOC, 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."