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2. The theory of liquidity preference and the downward slopingaggregate demand curve The following graph shows the money market in a hypothetical economy. The central bank in this economy is called the Fed. Assume that 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. 18 Money Supply O 15 Money Demand INTEREST RATE (Percent) 12 Money Supply 9 6 Money Demand 30 I I I I 0 20 40 60 80 100 120 MONEY (Billions of dollars) After the increase in the price level, the quantity of money demanded at the initial interest rate of 9% will be v than the quantity of money supplied by the Fed at this interest rate. People will try to 7 their money holdings. In order to do so, people will L bonds and other interest-bearing assets, and bond issuers will nd that they v interest rates until the money market reaches its new equilibrium at an interest rate of % . The following graph shows the economy's aggregate demand 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 O 60 Aggregate Demand 30 0 0 40 80 120 160 200 240 OUTPUT (Billions of dollars) The change in the interest rate that you found previously will cause residential and business investment spending to , leading to in the quantity of output demanded in the economy