Question 19.16

7. In the economy of Eastlandia, the money market is initially in equilibrium when the economy begins to slide into a recession.

  1. Using the accompanying diagram, explain what will happen to the interest rate if the central bank of Eastlandia keeps the money supply constant at image1.

    image

  2. If the central bank is instead committed to maintaining an interest rate target of r1, then as the economy slides into recession, how should the central bank react? Using your diagram from part a, demonstrate the central bank’s reaction.