Question

Question 2 During the late 70s and early 80s, the U.S. economy faced an inflationary period. The chairman of the Fed at that time, Paul Vocker, pursued a monetary policy to reduce inflation in the long run. The principal method used by the Federal Reserve to change the money supply is through open market operations.

(a) Which policy would accomplish the Fed's goal to reduce inflation (buy or sell bonds) in the long run?

(b) Use the Quantity Theory and Fisher Equation to explain what happens to the economy in the long run, particularly to: (i) prices and nominal output; (ii) real in GDP; (iii) inflation and nominal interest rate; (iv) money demand; (v) real interest rate

(c) Discuss the advantages and disadvantages of this policy regarding the trade-off between unemployment, output and inflation in the long run.

Answer 1

a) Here the policy selling bonds would help to reduce inflation. Because by selling bonds people will buy bonds in open market and this will reduce the supply of money which have with the people. This reduce in money supply through lower demand will help to reduce inflation.

b) In the quantity theory of money Fisher's equation is MV = PT, where M is supply of money, V is velocity of money, P is price level, T is transaction volume. Sometimes we can write this equation as MV = PY, replace only T by Y, where Y is level of current output.

i) When government purchase bonds from people the money supply will fall, it means M in the left side of the equation will fall. As a result overall MV falls as velocity of money assuming fixed. As a result price level P in the right side have to fall if Y is fixed. So overall nominal output will fall through fall in P or Y. It means P*Y will fall due to decrease in money supply M. Given Transaction fixed P has to fall.

ii) Real GDP will be falling or not falling depend on price level and current output level. If price level falls but current output does not fall then real GDP can increase but there is a possibility of decrease also if current output falls more compare to price level. There is no clear relationship with decrease in money supply and real GDP.

iii) As there will be price level there will be decrease in inflation. The nominal interest rate will go up because there will be low supply of money to give loans or for borrowing.

iv) As money supply declining through open market operations by selling bonds the money demand has to be fall because to maintain the equilibrium.

v) Real interest rate will go up as nominal interest rate increases and price level falls and therefore i/p will rise, where i is nominal interest rate and p is price level.

c) As there is inverse tradeoff between inflation and unemployment we can say due to fall in price level i.e due to lower inflation there will be higher unemployment. Higher unemployment can reduce output.