Question

If the economy is experiencing accelerating inflation, what (traditional) policy would the Federal Reserve System (Fed) implement with regard to interest rates? Explain briefly, including what specifically the Fed would do in the implementation of the policy. Note that the appropriate policy is the opposite of what the Fed would do to combat a recession. Show graphically how the Fed policy you described above would affect the market for loanable funds. Explain briefly.

Answer 1

This is my answer

a) To combat recession which brings the economy to a state where it produces a less than potential output, the central bank has to adopt expansionary measures that increase the money supply. Fed can conduct loose monetary policy by open market purchases of government bonds, reduce reserve requirements or the discount rate. In the money market, the current interest rate is now out of equilibrium.

With increased money supply, interest rate has to reduce in order to bring the market in the equilibrium, here, to a new level of demand for money. Lower interest rate will stimulate investment spending and so this shifts the AD to the right. Income will rise because the fall in the interest rate will stimulate investment spending, in tandem, affecting the Aggregate Demand. Consumption rises as income rises.

b. When the Fed uses expansionary monetary policy to stimulate the economy, banks are able to create money by advancing more loans. This implies that the supply of loable funds in the market is increased when the supply curve shifts to the right. This reduces the interest rate and increases the quantity of funds

Thank you...