The figure in this exercise depicts the money market. The demand for money is downward sloping, representing the inverse relationship between the interest rate – the opportunity cost of holding money instead of assets that earn interest – and the quantity of money held by the public. The purpose of holding money is to buy goods and services. The supply curve is vertical because the quantity of money supplied to the economy is determined by the Federal Reserve and does not respond to changes in the interest rate. Just like any other good or service, the price of money is represented graphically and determined by the intersection of its supply curve and its demand curve. You will want to know how interest rates respond to: changes in the supply of money, changes in income, and changes in the price level. Let's work with the graph.

1. If the Federal Reserve decides to increase the money supply, how will this increase affect the interest rate? Move the money supply curve to the right to find the answer. ?

The demand for money is positively related to the nominal value of the goods and services purchased, implying that the demand curve shifts to the right if either real output rises or if prices rise.

2. How do you expect an increase in the price level to affect the interest rate? Move the money demand curve to find the answer. ?
3. How do you expect a decrease in real output to affect the interest rate? Move the money demand curve to find the answer. ?
4. Now suppose you were in charge of the Federal Reserve and thought an increase in interest rates was necessary to stabilize the economy. Move the money supply curve rightward and then move it leftward to see how to accomplish this goal ?
5. Using knowledge you gained from Chapter 4 of the textbook, how does an open market purchase of government securities by the Federal Reserve affect the interest rate ?