In Country A, where the banking system has limited reserves, …

Advanced Placement (AP) Questions
Short Answer
Step by Step Solution
Advanced Placement (AP) Questions

In Country A, where the banking system has limited reserves, the central bank is concerned about a decline in investment spending. (a) What open market operation is the central bank likely to implement to address this issue? (b) Draw a labeled graph of the money market showing the effect of the policy identified in part (a) on the nominal interest rate. (c) Explain how the change in the nominal interest rate affects aggregate demand in the short run. (d) If the banking system had ample reserves instead, what policy action would the central bank likely take to address the decline in investment spending?

Short Answer

The central bank of Country A uses open market purchases to increase the money supply, which lowers nominal interest rates and encourages borrowing. This stimulates investment spending, boosts aggregate demand, and promotes economic growth, while potentially lowering reserve requirements for banks to enhance lending capacity.

Step-by-Step Solution

Step 1: Open Market Purchase

The central bank of Country A will initiate an open market purchase to address the decline in investment expenditure. This involves buying government securities from financial institutions. As a result, more funds are made available in the banking system, which helps to accelerate economic activity.

Step 2: Adjusting the Money Market Graph

By conducting open market purchases, the money supply increases, shown by a rightward shift in the demand curve on the money market graph. This shift lowers the nominal interest rate, making borrowing cheaper. A lower interest rate encourages businesses and consumers to take loans for investment and spending, effectively stimulating the economy.

Step 3: Motivating Investment Spending

A reduced nominal interest rate will likely lead to an increase in investment spending, which in turn boosts aggregate demand in the short term. If banking institutions have enough reserves, the central bank can lower the reserve requirements, providing banks with more money to lend. This further supports the cycle of investment and economic growth.

Related Concepts

Open Market Purchase

A monetary policy tool where a central bank buys or sells government securities to influence the money supply and interest rates

Money Supply

The total amount of monetary assets available in an economy at a specific time, which influences economic activity and interest rates

Nominal Interest Rate

The stated interest rate on a loan or financial product that does not account for inflation, affecting borrowing costs and consumer spending.

Table Of Contents
  1. In Country A, where the banking system has limited reserves, the central bank is concerned about a decline in investment spending. (a) What open market operation is the central bank likely to implement to address this issue? (b) Draw a labeled graph of the money market showing the effect of the policy identified in part (a) on the nominal interest rate. (c) Explain how the change in the nominal interest rate affects aggregate demand in the short run. (d) If the banking system had ample reserves instead, what policy action would the central bank likely take to address the decline in investment spending?

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