When the Fed increases the money supply through open market operations, it can take some time...

When the Fed increases the money supply through open market operations, it can take some time before the interest rate changes and new investment happens.

• Is this an example of inside or outside lag?

• Why does doesn’t the monetary expansion change GDP instantly? Provide an example relating to either the bank, the borrower, or another party in the economy.

Expert Solution

1.This is an example of outside lag. The outside lag is the amount of time it takes for a government or central bank's actions, in the form of either monetary or fiscal policy, to have a noticeable effect on the economy. The Fed has increased money supply but it willntakectime for policy to come into action, to boost demand and fight recession.

2.Money is neutral because nominal money supply has no effect on output and the interest rate in the medium run. The increase in the nominal money supply is entirely reflected in the proportional increase in the price level. The interest rate is determined by the position of the IS curve and the natural level of output (which is determined by the position of the AS curve). Because the IS curve doesn’t move, there is no effect on the interest rate (and level of investment) so that the level of output also does not change. Therefore in the medium run the monetary policy is not effective.

Rahul Sunny answered 2 years ago

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