The diagrammatic representation of an economy experiencing recession is shown below:
Figure-1: Aggregate Demand and Aggregate Supply
In figure-1, AD is the aggregated demand curve, SRAS is the short-run aggregate supply curve and LRAS is the long-run aggregate supply curve respectively. The economy is at the equilibrium point E which represents a situation of recession because aggregate demand is too low that it leads to a low production, the output is below the natural level of output. The recessionary gap is represented by Q N -Q. Since the output level is below its natural level, there unemployment is high.
In order to boost up the aggregate demand to restore the economy to its natural state, money supply in the economy can be increased. To increase money supply, the government can buy government securities from the public.
The effect of open-market operation on the money market is shown in Figure 2.
Figure-2: Open-Market Operations in Money Market
The money supply curve shifts from MS to MS 1. The resulting impact on the rate of interest is that it falls from r to r 1.
The effect of open-market operation on the economy is shown in figure 3.
Figure-3: Effect of Open Market Operations on Output and The Price Level
A fall in the interest rate results in an increase in the aggregate demand. The increase in the aggregate demand is shown in figure 3 by a shift in the AD curve to AD 1. In the shown scenario, the price level increases from P to P 1 and the aggregate demand has increased to such an extent that the economy is restored to its natural state, wherein the economy produces Q N level of output.
a. When the Fed's bond traders buy bonds in open-market operations, the money -supply curve shifts to the right from MS 1 to MS 2. The result is a decline in the interest rate.
Change in Money supply
b. When an increase in credit card availability reduces the cash people hold, the money-demand curve shifts to the left from MD 1 to MD 2. The result is a decline in the interest rate. Graphically, this can be seen as below:
Change in Demand
c. When the Federal Reserve reduces reserve requirements, the money supply increases, so the money-supply curve shifts to the right from MS 1 to MS 2. The result is a decline in the interest rate. The figure is same as in (a)
d. When households decide to hold more money to use for holiday shopping, the money-demand curve shifts to the right from MD 1 to MD 2. The result is a rise in the interest rate.
e. When a wave of optimism boosts business investment and expands aggregate demand, money demand increases from MD 1 to MD 2 in Figure 3. The increase in money demand increases the interest rate. Graphically, this can be seen as below:
a. The increase in the money supply will cause the equilibrium interest rate to decline. Households will increase spending and will invest in more new housing. Firms too will increase investment spending. This will cause the aggregate demand curve to shift to the right and it shows Quantity of output and Price level.
b. In the short run, the increase in aggregate demand will cause an increase in both output and the price level in the short run.
c. When the economy makes the transition from its short-run equilibrium to its long-run equilibrium, short-run aggregate supply will decline, causing the price level to rise even further.
d. The increase in the price level will cause an increase in the demand for money, raising the equilibrium interest rate.
e. Yes. While output initially rises because of the increase in aggregate demand, it will fall once short-run aggregate supply declines. Thus, there is no long-run effect of the increase in the money supply on real output.