Suppose that the Federal Reserve strictly follows a rule of keeping the interest rate at 3% per year. Initially, this interest rate equates the demand and supply of real money balances. The economy then experiences a negative shock to the demand for money. In other words, there is a drop in the demand for real balances that people want to hold at a given interest rate and real income.
(a) If the Fed didn't change the money supply, what would happen to the interest rate?
(b) If the Fed wanted to keep the interest rate constant following this money demand shock, how would it change the money supply?
(c) Suppose that over time the economy experiences many positive and negative demand shocks.
Further, suppose that the Fed follows a policy of always keeping the interest rate constant. Would the Fed's constant interest rate rule increase the variance of the money supply? Is this a bad thing under the circumstances?