Question

Short but detailed answer please:

Assume that the economy is currently in short run equilibrium but experiencing an inflationary gap.

1. Graphically illustrate the problem
2. Identify the combination of monetary policies that the Federal Reserve would pursue to correct problem
3. Graphically illustrate and explain how these monetary policies affect the market for reserves, the market for M1, and the market for real goods and services (AD-AS)
4. Make sure that you identify the Fed’s goals/objectives and also graphically illustrate the solution.

Answer 1

Below graph illustrate the problem:

At point E, The economiy is experiencing an inflationary gap as prices are higher than before. Full employment is at Yf.

To correct the problem, Fed adopts the contractionary monetary policy. This will reduce the flow of money into the economy. This will in turn reduce demand. The aggregate demand curve will shift leftward from AD1 to AD2 till the gap is closed and the economy is back to the full employment situation.

This move will impact the AD-AS market as shown in below diagram:

Price and GDP both reduce.

This policy will increase the reserves in the economy as the banks are liable to keep more money with themselves rather to lent them to the general public.

In the market for M1, the M1 money will decrease through this policy. As a result, interest rates will incresae as shown in below figure: