Question

Conducting Monetary Policy

1. (.5 marks) Should the Central Bank increase or decrease the discount rate to get the economy to full-employment output? For full credit, please describe the timeline of events / channel (what happens to relevant curves in money market and AD-AS model in a sequential manner).

1. (1.5 marks) The Central Bank decides to increase reserve requirement to 40% in order to close the output gap / get the economy to full-employment output. On the AD-AS graph, please draw which curve shifts and in which direction. Also, please draw what happens (shift/movement of any curve) in the money model graph too.

1. (.5 marks) To conduct Open Market Operations to follow an expansionary monetary policy, should the Central Bank buy or sell Treasury bonds? Justify / describe the channel of how the procedure works (Open Market Operations).

Answer 1

1) If the economy is below full employment level, Fed should reduce the discount rate such that it increased excess reserve banks holds and raise money supply in the economy. Rise in money supply will shift LM curve to its right while keep IS same which reduce rate of interest and raise output level.

Rise in money supply will raise aggregate demand in the economy which shifts aggregate demand curve to its right which raise price level.

2) If central bank reserve requirement, they will keep 40% of every deposit made with them which will raise their excess reserve and money supply which will raise money supply which shift LM curve to its right.

Rise in money supply raise cash holdings with people which tends to raise willingness to pay by consumers and raise aggregate demand in the economy which will shift aggregate demand curve to its right and raise price level.

3) Central bank should buy bonds in exchange of giving money to investors in the market to enact expansionary monetary policy in the market. Giving money to investors will inject money in the economy and raise money supply.