Answer the next 3 questions based on the following information: Starting from a recession (Y2 < Yf),...

Answer the next 3 questions based on the following information: Starting from a recession (Y₂ < Y_f), what would happen to the real interest rate (r) from there if the return to potential output (Y_f) was accomplished by each of the following? For each, you should write one of the following responses: Up, Down, or Same

If no policy were enacted.
If, instead, the Fed accomplished the return to Y_f through its use of monetary policy.
If, instead, Congress and the President accomplished the return to Y_f through its use of fiscal policy.

Expert Solution

*Assuming the recession was due to demand shock

a) When there is a recession price level decreases in the economy which will lead to fall in prices of inputs and aggregate supply will increase decreasing the prices further which will increase the real money supply in the economy which at given demand for money lead to decrease in interest rate. Hence, if no policy was inacted, interest rate would go down.

b) FED will use monety expansion to reach the long run equilibrium level of output, Yf. For which it will increase the money supply which, at given demand for money, will cause interest rate to decrease. Hence, if FED’s policy is inacted, interest rate will go down.

c) Congress and the President will use a fiscal expansion to bring back the output level to long run equilibrium level. This will increase the aggregate demand causing the transaction demand for money to rise which, at given supply of money, will cause interest rate to increase. Hence, if Congress’ policy is inacted, interest rate will go up.

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Rahul Sunny answered 8 months ago

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