Draw a graph of money market equilibrium.
a. Is the real or nominal interest rate on the axis? Explain why.
b. Let’s say the Fed wants to lower the nominal interest rate. Use your graph to show how they do this. Explain.
c. Define monetary neutrality. Explain how to use a graph of money market equilibrium to illustrate monetary neutrality.
1) First, use the graph to analyze the effect an increase in the money supply on the nominal interest rate.
2) Second, assume the price level rises proportionately as required by monetary neutrality. Use the same graph to illustrate the effect of this second shock on the nominal interest rate.
3) What is the effect of the increase in M and the same proportionate increase in P on M/P? What is the effect on the interest rate?