Suppose the monetary authority desires to restore the output to the long run equilibrium level. Should...

Suppose the monetary authority desires to restore the output to the long run

equilibrium level. Should the monetary authority raise or lower the target interest

rate? Describe the

open market operation that would be needed to move the

interest rate to the new target.

Solutions

Expert Solution

If output is less than long-run equilibrium (potential) output, there is a recessionary gap, which can be closed by decreasing the interest rate, by expansionary monetary policy using open market purchase of government securities that increases money supply. A fall in interest rate will increase investment demand and the portion of consumption demand funded by borrowing. Higher consumption and investment together increases aggregate demand, restoring output to its potential output level.

On the other hand, if output is higher than long-run equilibrium (potential) output, there is an inflationary gap, which can be closed by increasing the interest rate, by contractionary monetary policy using open market sale of government securities that decreases money supply. A rise in interest rate will decrease investment demand and the portion of consumption demand funded by borrowing. Lower consumption and investment together decreases aggregate demand, restoring output to its potential output level.

Rahul Sunny answered 1 year ago

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