1. Consider an economy where the central bank implements a contractionary
monetary policy, reducing the money supply. At the same time, due to economic
uncertainty, households and firms increase their preference for holding liquid
assets (money) rather than investing in bonds.
Using the Liquidity Preference Framework and diagrams,
(a) Analyze the effects of these two simultaneous changes on the equilibrium
interest rate. Where is this new equilibrium interest rate and money demand
level compared to old equilibrium, for the combined effects?
(b) How would the shift in money demand and money supply impact interest
rates differently if only one of the changes occurred?.
[In order to get full credit, you will need to use 3 diagrams]