3.5 Demand management - Monetary policy

The central bank conducts an expansionary open market operation by purchasing government bonds from commercial banks. This injects newly created money into the banking system.

The purchase shifts the vertical money supply curve rightward. With the downward-sloping money demand curve unchanged, the equilibrium interest rate falls.

Lower interest rates reduce borrowing costs for firms (encouraging investment, $I$) and households (encouraging consumption, $C$). Both components of $AD=C+I+G+(X-M)$ rise, shifting AD rightward.

The correct sequence is: bond purchase → money supply increases → interest rates fall → $C$ and $I$ rise → AD increases. This matches the first option exactly.

The question asks for the correct causal chain from an open market bond purchase to a change in AD. Every link in the chain must be directionally accurate.

Option 2 claims bond purchases raise interest rates and decrease AD — this is backwards. Bond purchases increase the money supply, which lowers interest rates.

Option 3 introduces government spending and taxes, which are fiscal policy tools unrelated to open market operations. Option 4 incorrectly states money supply decreases after a bond purchase — the opposite is true.

Only option 1 correctly states: bond purchase → money supply increases → interest rates fall → $C$ and $I$ rise → AD increases. This is the standard OMO transmission mechanism.

Raising the minimum reserve requirement is a contractionary monetary policy action. Banks must now hold back a larger fraction of deposits, leaving less available to lend.

Reduced bank lending capacity shrinks the quantity of money circulating in the economy. The vertical money supply curve (MS) shifts leftward — it moves to a smaller quantity at every interest rate.

The money demand curve ($MD$) is unchanged. A leftward shift of the vertical $MS$ curve creates a new intersection with $MD$ at a higher equilibrium interest rate.

The correct answer is: the money supply curve shifts leftward, raising the equilibrium interest rate. Central bank policy tools always shift the supply curve, not the demand curve.

The question asks which curve moves and in which direction in the money market diagram after the reserve requirement is raised.

Options 1 and 4 both claim the money demand curve shifts. Reserve requirement changes act on the quantity of money banks can supply — they have no direct effect on households' and firms' desire to hold money, so $MD$ does not shift.

Option 3 claims $MS$ shifts rightward — this would be the result of lowering the reserve requirement (expansionary). Raising the requirement forces banks to hold more in reserve, contracting the money supply.

Option 2 correctly identifies: raising the reserve requirement → banks lend less → money supply falls → $MS$ shifts left → equilibrium interest rate rises.