In: Economics
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.
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.