Question

The United States economy is currently operating above the full employment level of GDP.

1. Draw a correctly labeled AD/AS graph for this economy showing equilibrium output and price level.
2. Identify an open market operation that the Federal Reserve could enact that will solve the problem.
3. Show and Explain how the policy you identified in (B) will affect each of the following in the short-run.
   1. output and employment
   2. price level
   3. nominal interest rates
4. If the interest rates you identified in (C) continued, explain what will happen to the following:
   1. U.S. financial assets
   2. International value of the dollar

Answer 1

A.

In the above diagram, Q' is potential output, but economy is producing Q level of output that is above the potential output level.

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B.

Open market operation will involve selling government securities and bonds so that money is sucked out of the economy. It will discourage the consumption and investment spending in the economy.

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C.

In the short run, output will decrease in the economy. Unemployment level will increase, so employment will decrease. Price level will also decrease as AD curve shifts to the left.

Nominal interest rate will increase as money supply is decreased in the economy by the action taken up by Fed.

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D.

price of US financial assets will decrease as interest rate increases.

The value of dollar will appreciate as demand for USD will increase. further, foreign investors will come to the USA due to the higher interest rate. It will also increase the demand as well as exchange value of USD w.r.t. other foreign currencies.