Question

A) Suppose Inflation is higher than the Fed's target rate. To reduce Inflation, the Fed should .................... government bonds. This will in turn ................... money supply and .................. interest rates. In essence, what kind of Monitory Policy is the Fed Running here ?

B) If the Fed changes interest rate from 0.25% to 0.75% while the European central bank keeps the interest rate unchanged at 0.25% what would be the impact on : U.S. Capital Inflows (increases or Decreases)? U.S. Dollar (appreciates or depreciates) ? U.S. exports (increases or Decreases)?

C) In the 2008 recession, the Fed decreased interest rate but also the government had to run a budget deficit. Explain why fiscal policy tools had to be used in addition to the monetary policy too ? (Hint: explain why the monetary policy implemented was not adequate)

D) Other things being equal, if G>T, public savings are .............. and national savings ............ . This makes savings .............. investment and the country runs a trade ................... . If there is a budget deficit year after year, the economy ends up with a ........................ which is a burden on future generations.

Answer 1

(A) To reduce inflation, Fed should sell government bonds. This will decrease money supply and increase interest rates. In this, Fed is running Contractionary monetary policy.

(B) If Fed increases interest rate,

US Capital inflows will Increase. This will increase demand for dollar, so

US dollar appreciates. An appreciated dollar will mke US exportable goods less competitive, therefore

US exports Decrease.

(C) During recession, interest rates were already so very low that monetary policy was ineffective (in a liquidity trap). This is why additional expansionary fiscal policy measures were required to be taken.

(D) If G > T,

Public savings are lower and national savings are lower. This makes savings lower than investment and the country runs a trade deficit. If there is budget deficit year after year, economy ends up with a National debt spiral** which is burden on future generations.

**Provide dropdown options in Comment section for exact wordings.