Question

Show and explain using a graph with aggregate supply and demand and potential output, along with the basic equation Y = C + G + I + net exports, the policy goal of the aggressive lowering of the Fed’s target interest rate.

Answer 1

Greetings for the day,

First of all, we are going to understand the meaning of Aggregate supply, Aggregate demand and potential output or GDP:

Aggregate supply (AS) refers to the total quantity of output (i.e. real GDP) firms will produce and sell into the market.

Potential GDP/output is defined as the quantity that an economy can produce by fully employing its existing levels of labour, physical capital, and technology, in the context of its existing market and legal institutions.

Aggregate demand (AD) refers to the amount of total spending on domestic goods and services in an economy.

Aggregate supply and potential output:

Now first look into the graph then we will elaborate it further:

Aggregate supply (AS) curve slopes up, because as the price level for outputs rises, with the price of inputs remaining fixed, firms have an incentive to produce more and to earn higher profits. The potential GDP line shows the maximum that the economy can produce with full employment of workers and physical capital.

The horizontal axis of the diagram shows real GDP—that is, the level of GDP adjusted for inflation. The vertical axis shows the price level.

As the price level rises, the aggregate quantity of goods and services supplied rises as well because there is a law of supply which says that there is a direct relationship between price and quantity supplied.

The slope of an AS curve changes from nearly flat at its far left to nearly vertical at its far right. At the far left of the aggregate supply curve, the level of output in the economy is far below potential GDP, which is already defined above.

Aggregate demand:

The aggregate demand (AD) curve shows the total spending on domestic goods and services at each price level, now we will first see the graph and then discuss it in detail:

The AD curve slopes down, which means that increases in the price level of outputs lead to a lower quantity of total spending. The reasons behind this shape are related to how changes in the price level affect the different components of aggregate demand.

The following components make up aggregate demand:

Consumption spending (C), investment spending (I), government spending (G), and spending on exports (X) minus imports (M):

C + I + G + X – M.

Let’s look at these components in details:

The wealth effect holds that as the price level increases, the buying power of savings that people have stored up in bank accounts and other assets will diminish because they will use their saving to eaten away to some extent by inflation...

The interest rate effect is that as prices for outputs rise, the same purchases will take more money or credit to accomplish. This additional demand for money and credit will push interest rates higher. In turn, higher interest rates will reduce borrowing by businesses for investment purposes and reduce borrowing by households for homes and cars—thus reducing consumption and investment spending.

The foreign price effect points out that if prices rise in the United States while remaining fixed in other countries, then goods in the United States will be relatively more expensive compared to goods in the rest of the world. U.S. exports will be relatively more expensive, and the number of exports sold will fall. U.S. imports from abroad will be relatively cheaper, so the number of imports will rise. Thus, a higher domestic price level, relative to price levels in other countries, will reduce net export expenditures.

Now we will be talking about the policy goal related to interest rate:

When describing the monetary policy actions taken by a central bank, it is common to hear that the central bank “raised interest rates” or “lowered interest rates.” We need to be clear about this: more precisely, through open market operations the central bank changes bank reserves in a way which affects the supply curve of loanable funds. If they do not meet the Fed’s target, the Fed can supply more or fewer reserves until interest rates do. Recall that the specific interest rate the Fed targets is the federal funds rate. The Federal Reserve has, since 1995, established its target federal funds rate in advance of any open market operations.

Financial markets display a wide range of interest rates, representing borrowers with different risk premiums and loans that are to be repaid over different periods. In general, when the federal funds rate drops substantially, other interest rates drop, too, and when the federal funds rate rises, other interest rates rise.