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 150 to 175.

Shift the appropriate curve on the graph to show the impact of an increase in the overall price level on the market for money.

Money DemandMoney Supply051015202530121086420INTEREST RATE (Percent)MONEY (Billions of dollars)Money Demand Money Supply

Following the price level increase, the quantity of money demanded at the initial interest rate of 6% will be than the quantity of money supplied by the Fed at this interest rate. As a result, individuals will attempt to their money holdings. In order to do so, they will bonds and other interest-bearing assets, and bond issuers will realize that they 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.

Aggregate Demand0102030405060300250200150100500PRICE LEVELOUTPUT (Billions of dollars)Aggregate Demand

The change in the interest rate found in the previous task will lead to a in residential and business spending, which will cause in the quantity of output demanded in the economy.