Question

1. Imagine that rather than the government moving to close the GDP gap, the central bank decided to move instead. Specify what type of open market operations would it undertake to close the GDP Gap (inflationary gap)

Answer 1

Open market operations (OMO) refers to when the Federal Reserve purchases and sells U.S. Treasury securities on the open market in order to regulate the supply of money that is on reserve in U.S. banks, and therefore available to loan out to businesses and consumers. It purchases Treasury securities to increase the supply of money and sells them to reduce the supply of money.

1. Open market operations (OMO) refers to a central bank buying or selling short-term Treasuries in the open market in order to influence the money supply, thus influencing short term interest rates.

2. Buying securities adds money to the system, making loans easier to obtain and interest rates decline.

3. Selling securities from the central bank's balance sheet removes money from the system, making loans more expensive and increasing rates.

4. These open market operations are the method the Fed uses to manipulate interest rates.

Its open market operations are the tools it uses to reach that target rate by buying and selling securities in the open market. The central bank is able to increase the money supply and lower the market interest rate by purchasing securities using newly created money. Similarly, the central bank can sell securities from its balance sheet and take money out of circulation, putting a positive pressure on interest rates.

                                      The Federal Open Market Committee (FOMC) is the entity that decides on the Federal Reserve's monetary policy. The FOMC sets a target federal funds rate and then implements the open market operations that achieve that rate. The federal funds rate is the interest percentage that banks charge each other for overnight loans. This constant flow of vast sums of money allows banks to keep their cash reserves high enough to meet the demands of customers while putting excess cash to use.

An inflationary gap is a macroeconomic concept that measures the difference between the current level of real GDP and the gross domestic product (GDP) that would exist if an economy was operating at full employment. The inflationary gap exists when the demand for goods and services exceeds production due to factors such as higher levels of overall employment, increased trade activities or increased government expenditure. This can lead to the real GDP exceeding the potential GDP, resulting in an inflationary gap. The inflationary gap is so named because the relative increase in real GDP causes an economy to increase its consumption, which causes prices to rise in the long run. Key point to note is that for the gap to be considered inflationary, the current real GDP must be the higher than the economy-at-full-employment GDP (also known as potential GDP).

1. An inflationary gap is a macroeconomic concept that measures the difference between the current level of real GDP and the gross domestic product (GDP) that would exist if an economy was operating at full employment.

2. Key point to note is that for the gap to be considered inflationary, the current real GDP must be the higher than the potential GDP.

3. Government fiscal policies that can reduce inflationary gap include reductions in government spending, tax increases, bond and securities issues, interest rate increases, and transfer payment reductions.

Calculating Real GDP

According to macroeconomic theory, the goods market determines the level of real GDP, which is shown in the following relationship:

Y = C + I + G + NX

Where:

Y = real GDP

C = consumption expenditure

I = investment

G = government expenditure

NX = net exports

A government may choose to use fiscal policy to help reduce an inflationary gap, often through decreasing the number of funds circulating within the economy. This can be accomplished through reductions in government spending, tax increases, bond and securities issues, interest rate increases and transfer payment reductions.

These adjustments to the fiscal conditions within the economy can help restore economic equilibrium. By shifting the overall demand for goods, the adjustments control the amount of funds available to consumers. As the amount of money within an economy decreases, the overall demand for goods and services also declines.

               The Federal Reserve raised interest rates in response to inflationary activity, the increase would make borrowing funds more expensive. The increase in the associated expense lowers the number of funds available to most consumers resulting in lowered demand. Once equilibrium is reached, the Federal Reserve can shift interest rates accordingly.