Question

Suppose that Federal Reserve policy leads to higher interest rates in United States

a. How will this policy affect real GDP in short run if the United States is a closed economy (no exports and imports)?

b. How will this policy affect real GDP in short run if the United States is an open economy?

c. How will your answer to part b change if interest rates also rise in the other countries around the world?

Answer 1

The Federal Reserve's monetary policy stance leading to rise in interest rates and its effects on Real GDP can be explained through IS LM model.
a) Suppose the United states is a closed economy and we are considering short run period.

In the figure, the initial position is at point A where IS1 curve and LM1 curve intersects giving goods and money market equilibrium at interest rate r1,
Now Federal reserve through monetary policy raises the interest rates.
Consequently, the LM curve shifts to the left and the equilibrium is set at LM2 curve and IS1 curve intersecting at point B with a raised interest rate at r2.
The increase in interest rate and the consequent shifting of the LM curve decreases the real GDP as the income shifts from Y1 to Y2.
Reason: The increase in interest rates leads to dampening of domestic private investment and hence this affects aggregate demand, employment and most importantly GDP.

b) Supposing that United states is a small open economy in a short run period. The Federal reserve through its monetary policy raises the interest rates. Meaning: local domestic rate above the global interest rate leads to capital inflows.
This situation can be explained with the help of Mundell fleming model. Here, we assume that there is perfect capital mobility and US follow flexible exchange rate policy.

In this case, suppose the initial position is at point A where LM1 and IS1 curves are intersecting with a horizontal BOP curve showing perfect capital mobility. The interest rate is "r". The Federal reserves employs contractionary monetary policy. It leads to the shifting of the LM curve to the left (LM2 curve) at point B. The interest rate rises from r to ro. Consequently, there occurs massive capital inflow due to which there occurs appreciation of the currency which leads to decrease in exports and increase in imports. Hence it shifts the IS1 curve to the left (IS2 curve) Real GDP falls from Y1 to Y2.. Also, the capital inflow increases the foreign reserves and this leads to increase in money supply which reduces the interest rates back to the initial r. The economy finds itself at point C from A with a fall in real GDP.