Question

1. In the UK, during the Fall 2017 the key interest rate increased by 25 basis points. For a considerable time, the inflation rate was close to 3% and the pound depreciated due to Brexit and substantial debt. Use graphs and models to analyse the effects on all markets (real money balances market, IS-LM model). Explain effects on real interest rate, money demand and money supply.

Answer 1

Lom/ Interest Rate i a. Rate Interest & Md 2 » н" Mony x Money Market Output & i IS-LM Model

As is depicted in the above graph, increase in the key interest rates in the economy leads to decline in the level of money supplied in the economy to Ms' and thus in the money market, the equilibrium shifts from point E1 to E2 where interest rate in the economy has increased to Oi2 and quantity of money has also fallen in the economy. This increase in the real interest rate leads to fall in the quantity of money demanded in the economy.

In the IS LM Model in the above graph, fall in the quantity of money supplied shifts the LM curve leftwards to LM' and thus at new equilibrium point E2, the rate of interest has increased to oi2 and level of national output has fallen in the economy to OY2.