During the fourth quarter of 1993, real GDP in the United States grew at an annual rate of over 7 percent. During 1994, the economy continued to expand with modest inflation. (Y rose at a rate of 4 percent and P increased about 3 percent.) At the beginning of 1994, the prime interest rate (the interest rate that banks offer their best, least risky customers) stood at 6 percent, where it remained for over a year. By the beginning of 1995, the prime rate had increased to over 8.5 percent.

a. By using money supply and money demand curves, show the effects of the increase in Y and P on interest rates, assuming no change in the money supply.

b. On a separate graph, show that the interest rate can rise even if the Federal Reserve expands the money supply as long as it does so more slowly than money demand is increasing.