The FED (Central Bank in the USA) is watching the actions of the federal government and...

The FED (Central Bank in the USA) is watching the actions of the federal government and believes that federal government spending will increase next quarter which will lead to future rates of inflation greater than 3 percent.

a. Using the Money Supply Model explain how the FED will use its TOOLS and affect inflation. Define the key macro terms and the Money Supply Model in business friendly terms.

b. Businesses are concerned about both inflation and higher interests. Explain why they are concerned about higher inflation and higher interest rates.

Expert Solution

(a) In order to lower the inflation rate, Fed has to decrease money supply using contractionary monetary policy tools. Fed can achieve this by one or more of the following monetary policy tools:

- Open market sale of Federal securities,

- Increase in required reserves ratio,

- Increase in discount (Bank) rate.

A fall in money supply will increase real interest rate that will lower investment & consumption, thereby lowering aggregate demand, therefore decreasing inflation rate.

In following graph, MD0 & MS0 are initial money demand & money supply curves intersecting at point A with real interest rate r0 & quantity of money M0. As money supply falls, MS0 shifts left to MS1, intersecting MD0 at point B with higher interest rate r1 & lower quantity of money M1. Correspondingly, the lower panel shows AD-AS framework where initial aggregate demand curve (AD0) intersects initial short run aggregate supply curve (SRAS0) at point A with initial price level P0 and real GDP Y0, corresponding to initial r0 and M0. As interest rate rises, AD falls, shifting AD curve leftward to AD1, intersecting SRAS0 at point B with lower price level (inflation) P1 and lower real GDP Y1.

(b) Higher inflation increases menu costs and cost of inputs, which increases production cost. Unless demand rises correspondingly, higher cost lowers profitability. At the same time, higher interest rates makes borrowing more expensive, therefore firms lower investment demand required for expansion and growth. In addition, current costs of debt-servicing increases. Therefore, higher inflation and higher interest rates cause concern among businesses.

Rahul Sunny answered 2 years ago

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The FED (Central Bank in the USA) is watching the actions of the federal government and...

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