2. The theory of liquidity preference and the downward-slopingaggregate demand curve Suppose the money market for some hypothetical economy is given by the following graph, which plots the money demand and money supply curves. Assume the central bank in this economy (the Fed) fixes the quantity of money supplied. Suppose the price level increases from 90 to 105. Shift the appropriate curve on the graph to show the impact of an increase in the overall price level on the market for money. 12 Money Supply O 10 Money Demand O Money Supply 6 INTEREST RATE (Percent) Money Demand 2 20 40 60 80 100 120 MONEY (Billions of dollars)Following the price level increase, the quantity of money demanded at the initial interest rate of 6% will be v than the quantity of money supplied by the Fed at this interest rate. As a result, individuals will attempt to V their money holdings. In order to do so, they will V bonds and other interest-bearing assets, and bond issuers will realize that they V interest rates until equilibrium is restored in the money market at an interest rate of The following graph plots the aggregate demand curve for this economy. Show the impact of the increase in the price level by moving the point along the curve or shifting the curve. _\\ CD 180 - 0 15 Aggregate Demand 0 120 _l LIJ E | 90 Lu 0 2 n: n. 60 Aggregate Demand 30 0 I . 0 40 80 120 160 200 240 OUTPUT (Billions of dollars) 3. Changes in the money supply The following graph represents the money market for some hypothetical economy. This economy is similar to the United States in the sense that it has a central bank called the Fed, but a major difference is that this economy is closed (and therefore does not have any interaction with other world economies). The money market is currently in equilibrium at an interest rate of 4% and a quantity of money equal to $0.4 trillion, designated on the graph by the grey star symbol. 6.0 A 5.5 New MS Curve Money Demand 5.0 4.5 New Equilibrium 4.0 INTEREST RATE (Percent) 3.5 3.0 2.5 Money Supply 2.0 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 MONEY (Trillions of dollars)Following the price level increase, the quantity of money demanded at the initial interest rate of 6% will be V than the quantity of money supplied by the Fed at this interest rate. As a result, individuals will attempt to V their money holdings. In order to do so, they will Y bonds and other interest-bearing assets, and bond issuers will realize that they Y interest rates until equilibrium is restored in the money market at an interest rate of The following graph plots the aggregate demand curve for this economy. Show the impact of the increase in the price level by moving the point along the curve or shifting the curve. Show the impact of the increase in the price level by moving the point along the curve or shifting the curve. 180 O 150 Aggregate Demand 120 PRICE LEVEL 90 60 Aggregate Demand 30 0 40 80 120 160 200 240 OUTPUT (Billions of dollars) The change in the interest rate found in the previous task will lead to a V in residential and business spending, which will cause in the quantity of output demanded in the economy