5. The Federal Reserve faces an expansionary gap. How would you expect it to respond? Explain...

5. The Federal Reserve faces an expansionary gap. How would you expect it to respond? Explain step by step how its policy change is likely to affect the economy.

Expert Solution

Inflationary gap arises when actual GDP is greater than full employment GDP. In order to bring the economy back to full employment, federal reserve system would have to implement a contractionary monetary policy.contractionary monetary policy would make borrowing costly.

*Credit creation would fall and money supply would fall.

*As a result of fall in money supply, consumption investment and net exports will fall causing a fall in aggregate demand and the economy will eventually be back to having full employment level GDP.

This is shown in the following diagram.

Y* is the full employment GDP. But actual GDP is Y1 determined by the intersection of Short run aggregate supply curve with aggregate demand curve AD.Y1 is less than Y*. With the implementation of contractionary monetary policy, aggregate demand is reduced. So aggregate demand curve shift to left from. AD to AD 1 . intersection of AD1 with Short run aggregate supply curve brings the economy back to full employment level GDP.( prices also fall from P to P1)

Rahul Sunny answered 2 years ago

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