The theory of liquidity preference and the downward-sloping aggregate 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 following graph to show the impact of an increase in the overall price level on the market for the money.

Note: Select and drag one or both of the curves to the desired position. Curves will snap into position, so if you try to move a curve and it snaps back to its original position, just drags it a little farther.

Money DemandMoney Supply01020304050601815129630INTEREST RATE (Percent)MONEY (Billions of dollars)Money DemandMoney Supply

Following an increase in the price level, the quantity of money demanded at the initial interest rate of 9% will be more than the quantity of money supplied by the Fed at this interest rate. People will try to their money holdings. In order to do so, people will bond and other interest-bearing assets, and bond issuers will find that the 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 on the graph.

Aggregate DemandPoint Along AD0204060801001201801501209060300PRICE LEVEL OUTPUT (Billions of dollars)Aggregate Demand

The change in the interest rate that you found previously will cause residential and business investment spending too, leading to in the quantity of output demanded in the economy.