Lowering the nominal interest rate: Suppose the Fed announces today that it is lowering the fed...

Question

Lowering the nominal interest rate: Suppose the Fed announces today that it is lowering the fed funds rate by 50 “basis points” (that is, by half a percentage point). Using the IS-MP diagram, explain what happens to economic activity in the short run. What is the economics underlying the response in the economy?

Robert · Accepted Answer

A lower or higher interest is affected through an increase in money supply. Suppose the Fed 
decreases money supply  by either (i) Open-market sales of bonds, (ii) an increase in Reserve 
requirements or (iii) an increase in Fed’s Discount Rate. 
Now suppose, the Fed has lowered the money supply. At the existing nominal interest rate, 
demand of real money balances exceeds the quantity supplied. Agents now alter their asset 
portfolio by selling bonds or through withdrawing from bank deposits. Banks and bond 
issuers, in turn, to attract now-scarcer loanable funds, respond by increasing the nominal 
interest rate they offer. The new increased nominal interest rate,

Lowering the nominal interest rate: Suppose the Fed announces today that it is lowering the fed funds rate by 50 “basis points” (that is, by half a percentage point). Using the IS-MP diagram, explain...

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