Question

Show what happens to output, consumption and investment, wages and unemployment if the Federal Reserve contracts the money supply in the RBC model with nominal rigidities.

Answer 1

Contracting money supplies means a reduction in the amount of capital available in the economy. The Federal Reserve will sell bonds, raise tax rates, etc. to reduce surplus capital in the economy.

First of all, a decrease in the amount of revenue means that people would have less money to spend. Consumption would then decrease within the economy. This is private or household. Secondly, a fall in the supply of cash contributes to an rise in the interest rate, since the price of the cash is the rate of interest. This would lead to higher costs. Sales will be grow. When interest rates rise, loanable funds requirements decline. This lowers expenditure.

When demand and investment in the economy both decline, production will decline also. It causes the GDP production rates to decrease. Inflation typically accompanies contractionary monetary policy to raise borrowing costs to slow the recession.

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