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Because of the economic slowdown associated with the 2007–2009 recession, the Federal Open Market Committee of the Federal Reserve, between September 18, 2007 and December 16, 2008, lowered the federal funds rate in a series of steps from a high of 5.25% to a rate between zero and 0.25%. The idea was to provide a boost to the economy by increasing aggregate demand.

Use the liquidity preference model to explain how the Federal Open Market Committee lowers the interest rate in the short run.

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      Because of the economic slowdown associated with the 2007–2009 recession, the Federal Open Market Committee of the Federal Reserve, between September 18, 2007 and December 16, 2008, lowered the federal funds rate in a series of steps from a high of 5.25% to a rate between zero and 0.25%. The idea was to provide a boost to the economy by increasing aggregate demand.

      Why does the reduction in the interest rate causes aggregate demand to increase in the short run?

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      A fall in the interest rate leads to a rise in investment and consumer spending. This increase in investment and consumer spending leads to a rightward shift of the aggregate demand curve. For further review see section, “Monetary Policy and Aggregate Demand.”
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          Because of the economic slowdown associated with the 2007–2009 recession, the Federal Open Market Committee of the Federal Reserve, between September 18, 2007 and December 16, 2008, lowered the federal funds rate in a series of steps from a high of 5.25% to a rate between zero and 0.25%. The idea was to provide a boost to the economy by increasing aggregate demand.

          Suppose that in 2013 the economy is at potential output but that this is somehow overlooked by the Fed, which continues its monetary expansion. What happens to the price level and output in the long run?

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