Question

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   

A. FED increases the money supply to stimulate economy from recession.

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.

Answer 1

A. Increase in money supply will increase Consumption by consumers. As a result, AD will shift rightward and price level, output both will increase in short run and unemployment will decrease.

If this happens without limitation, the economy will experience inflationary gap. In this case, Fed should decrease money supply or, increase interest rate to reduce consumption and to stabilize the output.

B) A higher federal funds rate discourage bank to borrow from each other which tightens the money supply. As a result, in short run, AD will shift leftward and price, output both will decline. And unemployment will increase.

This may cause a recession. The fed should increase money supply and decrease interest rate to stabilize output by increasing aggregate demand.

C) This will shift AD rightward as people will consume more. In short run, both price and output will increase and unemployment will decrease.

FED should intervene by decreasing AD so that the economy will not face inflationary gap. To do so, the fed should decrease money supply or, increase interest rate(increasing interest rate will cause people to save more and spend less).