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Question 3: Monetary Policy Suppose the economy is in an inflationary gap, and the Fed responds...

Question 3: Monetary Policy
Suppose the economy is in an inflationary gap, and the Fed responds by conducting a
contractionary monetary policy.
b. Explain what the Fed does if it conducts open market operations to control inflation.
c. Explain the effects of this monetary policy on interest rates, business investments,
consumption spending, the value of the U.S. dollar, and the value of net exports.

Solutions

Expert Solution

Economy is in an inflationary gap implying that short run equilibrium GDP is greater than long run GDP. Fed responds by conducting a contractionary monetary policy. Under this case, it will attempt to decrease the money supply.

b. Now Fed conducts open market operations of selling government securities to depository institutions. Here these institutions purchase securities and in exchange they provide their reserves to the Fed. Now these institutions are left with fewer reserves so their lending capacity declines and they make fewer loans.

c. This raises the key interest rates including the federal funds rate. Higher interest rate would discourage business investments and so investment spending declines. Many consumers take home loans and other commercial loans so when they make less borrowing there is a decline in
consumption spending. Higher interest rate raises the demand for USD so that USD appreciates in its value.  This raises imports and decreases exports so that net exports decline.


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