Question

1. Monetary Policy
   1. What are the three tools of monetary policy?
   2. During a recessionary gap, as is currently being experienced, as signified by the

      designation that the economy entered into a recession in February of this year, what

      can and has the FOMC of the Federal Reserve done with regards to interest rates?

3. How will this change to interest rates affect AE and equilibrium GDP?

Answer 1

Monetary policy is the policy actions by the central bank to correct the economic situation.

a.

Three tools of monetary policy are:

1. Open market operation: It refers to the buying and selling of government securities by central bank in the open market. If central bank wants to increase the money supply in the economy then it should starts to buy government securities from people which cause money supply to rise.
2. Reserve requirement: It refers to the minimum amount of the total deposit that bank need to keep with itself or with central bank. If central bank wants to increase the money supply then central bank should decrease the reserve requirement so that commercial bank can provide more as a loan which cause rise in money supply.
3. Discount rate: It is the rate at which central bank provide short term loans to the commercial bank. If central bank wants to increase the money supply then it should decrease the discount rate which cause lending capacity of the commercial to rise and as a result they will provide more as a loan.

b.

Recessionary gap is the gap between actual real gdp and potential real gdp. Here actual real gdp is less than the potential real gdp. So to increase the actual real GDP to the potential level the central bank needs to use the expansionary monetary policy. Central bank can starts to sell government securities or decrease the reserve requirement or decrease the discount rate. All this will cause rise in money supply which results into fall in interest rates.

a.

AE= Consumption expenditure+Investment expenditure

Here investment expenditure is inversely related to the investment that is due to expansionary monetary policy the interest rate decreases which makes it cheaper to borrow from commercial bank at lower interest rate. So at lower rate, firms will borrow more and invest more. Rise in investment cause AE to rise and equilibrium Real GDP to rise as well.