Question

(1) Consider the situation below how it might affect the US market interest rate. (2) Draw a demand and supply for money as part of your answer (3) Explain briefly on your graph and reasoning. Please see an example on the next page.

The European countries’ interest rates are almost zero and some are negative. The US interest rates seem to be much higher than the EU interest rates. How might this affect the US market interest rate.

Answer 1

Higher US interest rate increases foreign investment in US, so dollar appreciates, which decreases exports and increases imports. Net exports fall, lowering aggregate demand and reducing inflation. As inflation falls, demand for money decreases, shifting money demand curve leftward, lowering market interest rate.

In following graph, MD0 and MS0 are initial money demand and supply curves intersecting at point A with initial interest rate r0 and quantity of money M0. As money demand falls, MD0 shifts left to MD1, intersecting MS0 at point B with lower interest rate r1.