Assume that the Fed’s primary goal is to cure inflation. How can it use open...

Assume that the Fed’s primary goal is to cure inflation. How can it use open market operations to achieve its goal? What is a possible adverse effect of this action by the Fed (even if it achieves its goal)? Show your work by using IS-LM framework. Discuss in details the repercussion of this on the different economic variables such as GDP, Price level, consumption, investment etc..

Expert Solution

Assume Fed primary goal is to reduce inflation, they can reduce this by reducing the supply of money in economy which reduce consumer willingness to pay for goods and result in fall in inflation. Reduction in supply of money will shift LM curve to its left from LM to LM1 which raise rate of interest and reduce output level.

Side effect of adopting this policy is that it lead to increase in rate of interest which reduce investment level in economy. As aggregate demand and investment are positively related, aggregate demand will also fall. Increase in rate of interest will induce people to save money which will reduce consumption level.

Rahul Sunny answered 2 years ago

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