Question

Short detailed answer please:

Assume that the economy is currently in short run equilibrium but experiencing a recessionary gap.

1. Graphically illustrate the problem
2. Identify the combination of monetary policies that the Federal Reserve would pursue to correct problem
3. Graphically illustrate and explain how these monetary policies affect the market for reserves, the market for M1, and the market for real goods and services (AD-AS)
4. Make sure that you identify the Fed’s goals/objectives and also graphically illustrate the solution.

Answer 1

In the short run it is possible that the AD curve and SRAS curve meet at an equilibrium real GDP which falls short of the potential level fixed under LRAS. When current GDP is less than potential GDP, there is a recessionary gap. The same is shown below.

At E, output is less than full employment level and unemployment is higher than its natural rate. Federal Reserve has an objective of price stability and maximum employment. To achieve this, it has to increase money supply to close the gap. Fed can reduce reserve requirement, discount rate or conduct open market purchase of government securities

In market for federal non borrowed reserves, this action will shift the supply curve to the right, reducing the federal funds rate. In money market, this action will shift the money supply curve to the right reducing the rate of interest. This raises investment spending and shifts AD to the right. As the aggregate demand is increased, GDP is increased and the recessionary gap is closed