Question

II. Monetary Policy For each of the event below, show the short-run effects on output, price and unemployment and explain how the Fed should adjust the money supply and interest rates to stabilize output B. FED increased the fed fund rate from 0.25 to 1.25% to fight against the potential high inflation rate. C. Without any intervention by FED, people holds more cash and banks hold more excess reserves due to market uncertainty. III. Fiscal Policy For each of the event below, show the short-run effects on output, price and unemployment and explain how the Fed should adjust the money supply and interest rates to stabilize output A. President Bush's tax cut the individual income tax by $2000 per household in 2003. B. Federal government issues the treasury bonds to finance the war in Iraq, and sell them to U.S citizens. C. Illinois state government increases income tax for the residents in Illinois to pay for education and pension deficits.

Answer 1

II ) B. FED increased the fed fund rate from 0.25 to 1.25% to fight against the potential high inflation rate :

The federal funds rate is the interest rate at which depository institutions (banks and credit unions) lend reserve balances to other depository institutions overnight, on an uncollateralized basis . So increasing this funds rate will reduce demand for such borrowing . Hence the money supply will decrease in short run . Interest rate rises in the economy . Investment spending declines . Aggregate demand decreases . Inflation declines . Both output and price come down . Unemployment increases .

C. Without any intervention by FED, people holds more cash and banks hold more excess reserves due to market uncertainty :

People holds more cash , so spending falls . Banks hold more reserves , so money supply falls . Interest rate rises in the economy because banks hold more reserves . Less spending causes fall of aggregate demand in the economy . Investment falls in the economy . Output and price both fall . There is a recessionary gap . FED should increase money supply or lower interest rate to stabilize the output .