Question

4. For each of the following event, indicate how the Fed should respond if the Fed is in charge of keeping output at its natural rate, regardless of what happens to the price level. In your answers indicate 1) if the Fed will increase or decrease the AD, 2) if the Fed will increase or decrease the interest rate, 3) if the Fed will increase or decrease the money supply, and 4) what open market operations will the Fed conduct.

a. OPEC raises crude oil prices.

b. The demand for new houses sharply decreases causing a major slow down in the housing market.

c. There is a stock market boom.

Answer 1

1) A higher price of oil causes the firms' production costs to increase. As a result, the aggregate supply in the economy will come down. The output declines causing the price level to increase. Thus, the federal bank will raise the aggregate demand in the economy to maintain the output at the initial level.

The aggregate demand can be made to increase when the federal bank brings the interest rate to a lower level (which can be done through an expansionary monetary policy). As a result of this, the investment in the economy increases along the part of consumption that is fulfilled through borrowings.

Thus, the money supply required to bring the interest rates down can be increased through the Fed buying securities in open market operations.

2) As the market for housing slows down, the aggregate demand falls. Fed will intend to bring the aggregate demand to a higher level to maintain the output from at the initial state.

Thus, the Fed brings the interest rate down to increase AD. This is because when the interest rate has declined, the investment will increase along with the consumption fulfilled through borrowings. Thus, AD rises.

The interest rates can be brought down through an increase in money supply. This increase in money supply can be brought by the Fed buying securities through open market purchase.

3) A boom in the stock market will push up the aggregate demand in the economy. The Fed steps in to maintain the output at the original level by causing AD to fall.

The aggregate demand will decline when the interest rates increase (because inveastments will fall and borrowings will decline as well). A rise in the interest rate can be brought about by making the money supply fall which can be done through the Fed selling securities in the market through an open market sale.