Money Supply versus Interest Rate Targets

Assume that the economy’s real GOP is growing,

What will happen to money demand over time?

Today we live in a world of scarcity where resources are limited due to high inflation experienced. Therefore one has to make a choice vital to the economy of the country. For instance, in US, the government and the Federal Reserve have control on the effect of supply and demand of money in the entire country(Schwartz, 2008).  Money demand is when people want to hold money rather than holding other types of assets. Any situation that causes people to hold money is bound to reduce the rate of money whereas situations that increase spending and investment shall increase rate of money. There is also a defensive demand for money over time due to perception of the future events that are bound to take place. This is money held for emergence expenditure. Since individuals with higher earnings in general do have higher expenses, they tend to hold more money for an emergency(Schwartz, 2008).  When there seem to be uncertainty about the future, the precautionary demand for money will be greater. For example, if you an employee who feels insecure about his current job will tend to hold more money because of the risk of losing his job in the future.

If the Fed leaves the money supply unchanged, what will happen to the interest rate over time?

In the case where FED does not change demand for money, the interest rate will fall since income is bound to reduce demand for money. This is because of the fact that interest must fall to restore money-market equilibrium. If the interest rate remains the same, the real interest rate will fall(Schwartz, 2008).

If the Fed changes the money supply to match the change in money demand, what will happen to the interest rate over time?

Money equilibrium have the disadvantage of not contribution to the nominal return.The advantage is that you can use them to do transactions like buying and selling of goods. Short term bonds have the benefitof earning interest; though, they have the disadvantage that they cannot be used to make transactions. Therefore, an investor will choose to allocate its portfolio between money and bonds considering the advantages and costs of the two instruments.

What would be the effect of the policy described in part (c) on the economy’s stability over the business cycle?

According to the US inflation sets off the business cycle. US economists hold this to be the most damaging effect of inflation. According to US theory, artificially low interest rates and the associated increase in the money supply may lead to reckless, speculative borrowing, resulting in clusters of investments, which eventually have to be liquidated as they become unsustainable(Schwartz, 2008).

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