Consider that content with the steady pace of economic recovery, the Federal Reserve Bank decides to undertake a large-scale asset sale resulting in a decrease in money supply.
a) What would be the effect of such a policy on equilibrium interest rate in the money market? Explain why the equilibrium interest rate changes the way it does. Provide a graphical illustration using the appropriate diagram(s).
b) Discuss the effects of the policy on equilibrium output and interest rate in the economy using the ISLM-ADAS model in the short run. Explain which market (or markets) is (or are) affected and which curves shift. Illustrate your answer with the appropriate diagrams.
c) Now discuss the effects in the medium run. You do not need to draw new diagrams; but you should refer to the diagrams in part b above and state which curves shift and in which direction they shift, and what happens to output and the interest rate in the medium-run equilibrium. A branch of the economics profession has argued that money is “neutral”. Does your analysis support this claim? Explain.