Question

The MP curve in the short run model assumes that monetary policy heavily influences the real interest rate in all credit markets. This is a bit of an oversimplification and there are a number of steps that must occur for this link to remain strong.  

What tool does the U.S. Federal Reserve use to conduct policy? Explain the chain of events from policy to credit markets.

Next, once real interest rates have responded to the monetary policy, explain how this will cause a change in the output gap

Answer 1

The federal reserve uses following tools to conduct policy :

1. The discount rate - the interest rate Reserve bank charges commercial banks for short term loans . Federal reserve lending at the discount rate complements open market operations in acheiving the target federal funds rate and serves as a backup source of liquidity for commercial banks.

2. Open market operations - the buying and selling of US government securities, has been a reliable tool. This tool is directed by the FOMC and carrued out by the Federal Reserve bank of New york.

3. Interest on reserves - interest on reserves is paid on excess reserves held at reserve banks . The current policy of paying interest on reserves allows the federal reserve bank to use interest as a monetary policy tool to influence bank lending.

Real interest rates cause a change in the output gap because :

An increase in the real interest rate leads to lower investment, lower real output , and hence a lower output gap.

A decrease in the real interest rates leads to higher investment, higher real output, and hence leads to a higher output gap.

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