Because of the economic slowdown associated with the...

Because of the economic slowdown associated with the $2007-2009$ recession, the Federal Open Market Committee of the Federal Reserve, between September $18,2007,$ and December $16,2008,$ lowered the federal funds rate in a series of steps from a high of $5.25 \%$ to a rate between zero and $0.25 \%$. The idea was to provide a boost to the economy by increasing aggregate demand. a. Use the liquidity preference model to explain how the Federal Open Market Committee lowers the interest rate in the short run. Draw a typical graph that illustrates the mechanism. Label the vertical axis "Interest rate" and the horizontal axis "Quantity of money." Your graph should show two interest rates, $r_{1}$ and $r_{2}$ b. Explain why the reduction in the interest rate causes aggregate demand to increase in the short run. c. Suppose that in 2015 the economy is at potential output but that this is somehow overlooked by the Fed, which continues its monetary expansion. Demonstrate the effect of the policy measure on the $A D$ curve. Use the $L R A S$ curve to show that the effect of this policy measure on the $A D$ curve, other things equal, causes the aggregate price level to rise in the long run. Label the vertical axis "Aggregate price level" and the horizontal axis "Real GDP."

Because of the economic slowdown associated with the $2007-2009$ recession, the Federal Open Market Committee of the Federal Reserve, between September $18,2007,$ and December $16,2008,$ lowered the federal funds rate in a series of steps from a high of $5.25 \%$ to a rate between zero and $0.25 \%$. The idea was to provide a boost to the economy by increasing aggregate demand.
a. Use the liquidity preference model to explain how the Federal Open Market Committee lowers the interest rate in the short run. Draw a typical graph that illustrates the mechanism. Label the vertical axis "Interest rate" and the horizontal axis "Quantity of money." Your graph should show two interest rates, $r_{1}$ and $r_{2}$
b. Explain why the reduction in the interest rate causes aggregate demand to increase in the short
run.
c. Suppose that in 2015 the economy is at potential output but that this is somehow overlooked by the Fed, which continues its monetary expansion. Demonstrate the effect of the policy measure on the $A D$ curve. Use the $L R A S$ curve to show that the effect of this policy measure on the $A D$ curve, other things equal, causes the aggregate price level to rise in the long run. Label the vertical axis "Aggregate price level" and the horizontal axis "Real GDP."

Key Concepts

Liquidity Preference Model

This model explains how individuals' demand for money balances is determined by interest rates. In it, the public prefers to hold money for transactions and precautionary reasons, but must balance that preference with the opportunity cost of holding money instead of interest-bearing assets. The model thereby demonstrates how an increase in the money supply, with a fixed money demand, leads to lower interest rates as the equilibrium in the money market is adjusted.

Open Market Operations

Open market operations are a primary tool of monetary policy used by central banks to adjust the supply of money in the economy. By purchasing securities, the central bank increases the money supply, which leads to lower interest rates. Conversely, selling securities reduces the money supply and increases interest rates. This tool is crucial in managing short-term interest rates and influencing overall economic activity.

Interest Rates and Aggregate Demand

Interest rates play a critical role in aggregate demand by affecting borrowing costs for consumers and firms. A reduction in interest rates lowers the cost of borrowing, which encourages spending and investment, thereby shifting the aggregate demand curve to the right in the short run. This mechanism is a fundamental link between monetary policy actions and their impact on the broader economy.

Aggregate Demand and Long-Run Aggregate Supply (LRAS)

The aggregate demand (AD) curve represents the total spending on goods and services in an economy at different price levels, while the long-run aggregate supply (LRAS) curve represents the economy's potential output at full employment. In the short run, monetary expansion can shift the AD curve to the right, increasing output and prices. However, if the economy is already at potential output, continued monetary expansion in the long run results primarily in a higher price level, as the LRAS is vertical and output remains unchanged.

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