Question

on chapter 15 and 16 explain how the federal reserve can use open market operation reserve requirement and fed funds/discount rate policies to resolve an exonomy with an inflationary gap.

Answer 1

Answer - The ways in which inflationary gap can be resolved through

1 - Open market operation - If the fed conducts the open market sale of government securities , the public and the commercial banks will purchase them in return for money. Thus money suppply in economy will reduce and interest rates will rise. This will decrease the AD in the economy and inflationary gap can be covered

2 - Reserve requirement - If the fed increases the minimum amount of reserve requirement , banks will have to keep more money as reserve and will have lesser amount for lending out. This will decrease the supply of money in economy , interest rates will rise , investment will fall. AS will decrease and hence inflation will reduce

3 - Discount rate - If the federal reserve bank decides to increase the discount rate , the rate at which banks borrow money will increase. Hence at greater discount rate , banks will borrow less amount and therefore will have lesser amount for lending. This will decrease the money supply in the economy and hence reduce consumption and investment and reduce AD.

Thus with the help of these tools , inflationary gap can be cured.