Alright. So let's go through this example together and see how the relationship between the money market and our interest rates affect the aggregate demand curve. In this example, the Fed intends to stimulate the economy by lowering interest rates. Lower interest rates are going to incentivize businesses to invest by providing lower interest rates for their loans, right? It's going to incentivize consumption, just like we discussed above. So the first question is: what open market operation should the Fed use to lower the interest rates? Let's think about our money market, right? The Fed wants to lower interest rates. Remember that our y-axis represents the interest rate in the market, the price of money being the interest rate, and the quantity of money is fixed by the Fed. Initially, the quantity of money available at our first equilibrium was fixed by the Fed at Q1, and we had this equilibrium interest rate, which we'll say R1 was our original equilibrium interest rate.
Just looking at the graph, remember that the Fed is going to affect the money supply. They're either going to increase or decrease the money supply to find a lower equilibrium interest rate. So what do you think? Do you think that the Fed wants to increase the money supply or decrease the money supply? Try to visualize on this graph where the new equilibrium would be if we increase the money supply, or the new equilibrium if we decrease the money supply. The Fed would want to increase the money supply to decrease the equilibrium interest rate. They want a lower interest rate. So, by increasing the money supply, let's draw a new money supply curve here which is increased. They've increased the quantity of money available to Q2. So at Q2, what's our equilibrium interest rate? It's lower. We see that there's a new point where they intersect down here, and we have a lower equilibrium interest rate.
In this case, by increasing the money supply, the equilibrium interest rate decreases. That's exactly what the Fed wants to do in this example: lower interest rates. So how do they increase the money supply? What open market operation do they go through? Remember that the open market operations mean that the Fed can either purchase securities or sell securities. If they want to increase the money supply, that means they want to put more money in the hands of the public. So, let's think about an open market operation. I like to draw this little diagram with the Fed and the public. We're going to have something going from the Fed to the public and something going from the public to the Fed in this transaction. What is the Fed going to give to the public? The Fed wants to increase the money supply, right? So they want to give money to the public. We're going to see dollars going to the public, and what's coming from the public to the Fed are the treasury securities that they're buying from the public. The money is going to the public.
Did the Fed go through an open market purchase or an open market sale? They did a purchase. The Fed purchased securities. So the answer to part a is: purchase securities from the public. That is the open market operation the Fed is going to go through here to have a higher money supply and a lower equilibrium interest rate. Now, let's think about question b. What effect will the lower interest rate have on aggregate demand? Remember that aggregate demand is composed of consumption, investment, government purchases, and net exports. We already discussed how a lower interest rate is going to increase our consumption, investment, and net exports. So we would have some sort of chain effect like this: a lower interest rate leading to higher consumption, investment, and net exports. All of these components are going up, which in turn leads to higher aggregate demand.
On our aggregate demand curve, we had the price level, so the general price level in the economy on the y-axis and we had GDP. So at a lower interest rate, what do we see? A new aggregate demand curve shifted to the right from AD1 to AD2. This would have all sorts of implications on the aggregate demand, aggregate supply, and the new equilibrium in our AD-AS model as well. But just for now, it's good to know that this effect in the money market, by affecting the money market through this increase in the money supply, is going to affect our aggregate demand because that lower interest rate is going to increase aggregate demand. This is a useful mechanism that the Fed might use during a recession. We've learned that during recessions, it's generally due to a lack of spending. There's not enough spending going on in the economy, and everything's kind of slowing down, leading the economy into a recession. So, something the Fed can do is go through an open market purchase of securities to increase the money supply, which decreases the equilibrium interest rate, and that decreased equilibrium interest rate incentivizes more spending from consumption, investment, and net exports. Okay? So let's pause here and talk about one more relationship between these two graphs.