1.The Federal Reserve is the central bank of the United States and is tasked with conducting...

1.The Federal Reserve is the central bank of the United States and is tasked with conducting monetary policy.

a.What is the “dual mandate” of the Federal Reserve?

b.Suppose the United States is currently experiencing high inflation and negative cyclical unemployment. Draw a graph of the AD‐AS model depicting current economic conditions. Then name three appropriate monetary policy actions

c.Graph the effect of the policy actions in part b in the money market. What happens to the short‐term nominal interest rate?

d.Graph the effect of the result from part c in your AD‐AS model from part b. If any curves shift, briefly explain why. What happens to real GDP, prices, and unemployment as a result of the policy action?

Solutions

Expert Solution

(a) Dual mandate of Fed is the twin objectives of maximizing employment while keeping inflation rate stable, and to moderate the long run interest rate.

(b) In following graph, long run equilibrium is at point A where aggregate demand (AD0), short-run aggregate supply curve (SRAS0) and long-run aggregate supply curve (LRAS0) intersect with initial price level P0 and real GDP (potential GDP) Y0. When there is high inflation and negative cyclical unemployment, it means that real GDP is currently higher than potential GDP and position of AD curve is at AD1 where it intersects SRAS0 at point B with higher price level P1 and higher real GDP Y1, creating an inflationary gap equal to (Y1 - Y0).

To lower inflation rate, Fed should engage in contractionary monetary policy by one or more of the following:

(i) By engaging in open market sale of Federal securities

(ii) By raising discount rate

(iii) By raising required reserves ratio.

(c) In money market, contractionary monetary policy will lower the supply of money which will increase interest rate in short run. In following graph, MD0 & MS0 are initial money demand & supply curves intersecting at point A with initial interest rate r0 & quantity of money M0. As money supply falls, MS0 shifts leftward to MS1, intersecting MD0 at point B with higher interest rate r1 and lower quantity of money M1.

(d) Higher interest rate will increase the cost of borrowing for firms which will lower investment and produce less output, decreasing aggregate supply. SRAS wll shift leftward and new long run equilibrium will be at a higher price level but restoring real GDP to potential GDP level. Price level will be higher, unemployment will fall to natural rate of unemployment and real GDP will equal potential GDP. In above graph, new long run equilibrium is at point C where shifted SRAS curve, SRAS1, intersects AD1 with higher price level P2 and real GDP (potential GDP) Y0.

Rahul Sunny answered 1 year ago

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