Question

Investment demand and the market for money are shown in the graphs below. If the economy has a recessionary gap of $100 billion and the MPC is 0.8, what level of the money supply should the central bank target if it wants to bring real GDP back to the full- employment level? Demonstrate your answer graphically. Instructions: Use the tool provided 'Sm2' to draw the new money supply curve. Use the graph on the right to plot your line such that the first point touches the horizontal axis. Investment Demand The Market for Money 12% 12% Sm 10% 10% 8% 8% Real rate of interest (percent) 6% Real rate of interest (percent) 6% 4% 4% 2% 2% D Dmi 0 0 $10 $20 $30 $40 $50 $60 $50 $100 $150 $200 $250 $300 Amount of investment (billions of dollars) Money demanded and supplied (billions of dollars)

Answer 1

mAns. Investment increase required to bring the economy back to full employment level = Recessionary gap / Spending multiplier

Investment Demand The Market for Money 12% 12% New Money Supply 10% 10% 8% 8% Real rate of interest (percent) 6% Real rate of interest (percent) 6% 2% 2% Dm1 0 0 0 $10 $20 $30 $40 $50 $60 $50 $100 $150 $200 $250 $300 Amount of investment (billions of dollars) Money demanded and supplied (billions of dollars)

Here, Spending multiplier = 1/(1-MPC) = 1/(1-0.8) = 5

Thus, investment increase required = 100 billion /5 = $20 billion

At present the interest rate in the money market is 8% (where money demand and money supply curve interests). At 8% interest, the investment spending is $20 billion and required increase in investment spending is $20 billion. So, total investment must be $40 billion which occurs at 4% interest.

So, to decrease interest rate to 4%, the central bank must increase by $100 billion to $200 billion.

Thus, to fill the recessionary gap, the central bank must increase money supply by $100 billion.

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