Question

(a) Using the Aggregate Demand (AD) model diagram, illustrate what happens to the equilibrium level of aggregate output when the Federal Reserve (Fed) engages in a tightening of monetary policy. Make sure you properly label all the axes and curves.

(b) Would the Federal Reserve be more likely to engage in a tightening of monetary policy during an expansion or recession? Explain in one sentence.

(c) Has the Federal Reserve recently (past 1-2 months) been engaging in a tightening of monetary policy (yes or no)? Explain in one sentence.

Answer 1

(a) Aggregate Demand (AD) is likely to decrease when there is a tightening of monetary policy. This is perhaps because the rate of interest is increased when there is a tightening of monetary policy by the Federal reserve where the money supply is reduced. This reduces investment spending and so AD curve shifts to the left. This reduces real GDP and price level in the short run.

(b) Federal Reserve would be more likely to engage in a expansionar monetary policy during a recession and a tightening of monetary policy during a recession. This is because when there is an expansion in the economy, real GDP might increase beyond its full employment level and this results in an inflationary gap. The demand pull inflation is required to be reduced and therefore tightening monetary policy is applicable

(c) Federal Reserve has been engaging in an expansion of monetary policy due to the Global pandemic that is hitting the economy as well. Recently it has reduced the Federal fund rate to 0% which is a part of monetary expansion